Many of us will look into buying an investment property knowing that it will provide the ability to obtain a tax deduction for the ongoing interest expense on the money we borrow to purchase the property. The expectation is that the value of the property will increase over a length of time, giving us a nice capital gain and higher rent income in the future is attractive.
In fact, today we get a tax deduction against our income tax at a rate of up to 45% (depending on individual tax rates) for the interest expense and we potentially only pay tax on 50% of any capital gains we make from the property when we choose to sell it in the future.
It is no wonder investing in property has become popular as a sound financial strategy from a taxation perspective.
What are the rules on whether the interest on a loan is tax deductible?
In brief and as specified by the Tax Act, a borrower can claim a tax deduction for interest on an investment property loan because it is an expense (allowable deduction) incurred during the process of earning an Assessable Income.
Your Assessable Income is usually the rental income you receive or expect to receive from a property; it does not include capital gains (covered under the Capital Gains Tax rules). It is important to keep this in mind during the process of researching property investing.
Your purpose will help dictate whether the interest is tax deductible.
Knowing the purpose of your loan will help determine whether the interest on your property loan is tax deductible.
For example, you are able to borrow again your principle place of residence and use these funds to purchase an investment property. The home will act as the security for your loan but the purpose should entitle you to take advantage of tax deductions on the interest of this loan. It’s crucial to keep records of how loan funds are being disbursed as proof for the tax office in the case of an audit.
It’s also important to think about your purpose if you are considering refinancing, as it will be detrimental to you if you accidental change the tax deductible loan purpose.
Why should I have an Offset Account?
Now that you have an understanding of how tax deduction on an investment property works, here’s why every property investor should have an Offset Account:
· An Offset Account helps you to ensure you do not accidentally alter the loan purpose; and
· Assists you in keeping clear and separate records as proof to the Tax Office.
Mary decides to purchase an investment property for $500,000. To do so she offers a mortgage over her owner occupied home worth $750,000. Mary is still eligible to claim a tax deduction on the interest of the loan for her investment property even though it is not mortgaged because the purpose of the loan was to buy an asset that would produce an assessable income.
Later, Mary comes into some money ($200,000) through a family member and decides to use it to bring the original loan down to $300,000 in order to save interest. As a result, Mary is ahead on her mortgage and can re-draw funds as she likes.
A year later, Mary decides to do an extension on her owner-occupied home and re-draws the $200,000 from her loan. The original purpose of the $200,000 for the loan has now changed. Mary now has a $300,000 tax deductible loan and a $20,000 loan which is not tax deductible.
Mary has inevitably diluted her $500,000 tax deductible debt and, as a result, caused herself some accounting strife. In the future, it will be unclear whether she is reducing the original tax deductible loan or non-taxable loan when she makes a repayment against the loan. While she may say that she is paying off the tax deductible loan, the Tax Office may not see it that way. This therefore removes her ability to claim a tax deduction on the $200,000.
How can this be avoided?
Mary could have avoided these issues by attaching an Offset Account to her investment loan. This is a completely separate account linked to the loan account that reduces the gross amount of the loan account to give a net balance each month. The bank uses that balance to calculate interest. Therefore, the account acts the same way as a savings account does. Mary could have parked the $200,000 here for as long as she wanted without reducing or altering the original purpose when she made repayments again this amount.
This would mean that Mary would have the same amount of interest on the loan but also preserve the maximum tax deductibility into the future.
Mary’s example shows just how important it is to seek advice about your home loan and financial goals so that you can enjoy the greatest benefits on your investment. It’s not just interest rates that are important; loan structure, service and advice is critical ensuring you receive the best results when combined with competitive rates.
MyChoice Home Loans will take the time to really understand your circumstances and tailor a loan to suit your unique needs.
Read more about our construction loans for investors or contact us today for more information.