The ATO states simply on their website that if you take out a loan to purchase a rental property, you can claim the interest charged on that loan, or a portion of the interest, as a deduction. However, the property must be rented, or available for rental, in the income year for which you claim a deduction. If you start to use the property for private purposes, you cannot claim the interest expenses you incur after you start using the property for private purposes.
However, with the plethora of financial products available, including split loans, sub-accounts, redraw facilities and equity-release loans, lines start to blur and property investors risk running foul of rules relating to tax-deductible interest.
Pitfall 1: Claiming interest where part of the loan was used for private purposes
It’s a common misconception amongst property investors that if a loan has been secured against an investment property, the interest on the loan is tax deductible. However, this is incorrect. The use of funds (ie. what the loan funds were used for) determines whether the interest on the loan is deductible. Therefore, a property investor needs to ask the question: ‘What were the funds used for?’
A loan might be obtained to purchase both a rental property and, for example, a private car. In cases of this type, the interest on the loan must be apportioned into deductible and non-deductible parts according to the amounts borrowed for the rental property and for private purposes.
Pitfall 2: Claiming interest for new home after renting out previous place of residence
Some rental property owners borrow money to buy a new home and then rent out their previous home. If there is an outstanding loan on the old home and the property is used to produce income, the interest incurred on the outstanding loan is tax deductible. However, an interest deduction cannot be claimed on the loan used to buy the new home because it is not used to produce income. This is the case whether or not the loan for the new home is secured against the former home.
This issue can be avoided by having an Offset Account attached to to the original loan. An Offset Account is a totally separate account which is linked to the loan account and reduces the gross amount of the loan account to give a net balance each month on which the bank calculates interest. The Offset Account acts like a savings account where the funds can be withdrawn and used to any purpose without reducing or altering the original purpose of the loan.
For example, a home owner purchases a home for $500K with a $100K cash deposit and $400K interest-only loan.
(a) He makes additional principal repayments on the loan, totallling $180K over several years and eventually, the loan balance is $220K. Subsequently, when he rents out this property, interest deductibility on the loan is limited to interest on the loan balance of $220K. This is the case even if he redraws $180K or takes up an equity release loan of $180K to purchase a new place of residence. He will have to arrange for a split loan, where the $180K loan (where interest is tax deductible) separate from the $220K loan (where interest is not tax deductible)..
The exception to this is when the $180K is used to purchase another investment property, in which case, then interest will be fully tax deductible.
(b) However, if he had maintained a 100% offset account and deposited the entire amount of $180K into the offset account, the loan balance would remain at $400K. Subsequently, when he rents out this property, interest deductibility on the loan is based on the full loan balance of $400K. He is free to withdraw the funds of $180K from the offset account to purchase a new place of residence without impacting on the interest deductibility of the $400K loan balance.
Disclaimer: This blog post has been simplified to cover the common scenarios relating to interest deductibility. This should not be construed as advice from Glint Accountants. Therefore, we encourage readers of this blog post to contact Glint Accountants for assistance with their specific circumstances.
Geraldine Lee is a Fellow of CPA Australia with an investment property portfolio that includes residential and commercial properties interstate, locally and overseas. She is well-versed in the complexities of Australian taxation laws and how they apply to investment properties. Contact us at Glint Accountants for assistance with your tax return.