If it is possible that the owner occupied home you are about to purchase may in your future be rented as an investment property you need to put the correct strategy in place before you buy this home as there are critical taxation issues which if not addressed before can cost you potentially tens of thousands in the future.
I must preface the following by stating I am a mortgage broker not a tax adviser. The following is my understanding of the situation from my experience with clients over the last 10 years. Please have this confirmed professionally.
The tax office considers the deductibility of interest on a loan based on the purpose of the borrowing. Obviously if you occupy the property the purpose of the borrowing is not deductible. The problem arises when you then move out of that property and rent it out so it becomes an investment property – let’s call this property P1. Many people think they can simply redraw on the original loan and use those funds to purchase a new owner occupied property (let’s call it P2 worth $500,000) – and of course you can, however:
- the tax office will consider the deductible borrowings on the P1 to be the minimum loan balance on the property during the period of owner occupancy – not the balance after you redraw as a result the redrawn funds are not deductible,
- you then use the redraw and purchase P2 however all of your funds for P2 are borrowed and none of them are deductible. Your gearing is all out of whack with $500,000 non-deductible borrowing and only the minimum debt on P1 deductible and to make matters worse – your rental income on P1 will now be approaching the interest costs and you are in danger of becoming positively geared and losing further tax benefit.
When clients come to me with this situation it is too late to correct. Usually their tax advice is to sell P1 use all funds for P2 then use that equity to purchase a new P3. The problem is you have selling costs on P1 and stamp duty on P3 – tens of thousands in costs just to end up with the same asset position, but geared correctly.
THERE IS A SOLUTION
Many lenders and brokers spruik about 100% offset accounts being a great way to pay your home off faster. In reality there is little evidence to support that for most normal income earners. However an offset account has enormous import for this situation. The ATO considers an offset account to be a separate bank account and therefore treats it independently of the loan account. The solution for you is
- apply now for a loan for P1 preferably as an interest only home loan – you do not want to reduce your future deductibility. This must be done before your loan repayment begin to reduce the principal so it best done from the start,
- establish a linked 100% offset account and you make all the additional payments you would have made on P&I loan plus extra payments into the offset account – not the loan account. You are paying interest on the net balance – therefore the loan is costing you exactly the same as if you were paying P&I. Your net borrowing decreases however the original loan limit balance on the loan account remains.
- Let’s say after 4 years you decide to rent P1 and purchase P2- you withdraw (not redraw) your funds from the offset account – the balance of the P1 loan account has not reduced – the purpose has changed to investment and so the interest on the entire loan amount is deductible.
- You use the funds from the offset say $75,000 as deposit and borrow $425,000 – you have reduced your non-deductible borrowing by $75,000 and your deductible loan balance is full original amount and at this point in time the ATO are absolutely ok with that.
I hope that makes sense and if you do intend to rent out your home in the future I strongly urge you to confirm this advice and then follow it.
This is a repost of an article that I wrote on peachfinancial.com.au