How does interest deductibility work?
The first thing to understand about deducting interest is the purpose of the loan. For interest to be tax-deductible, the borrowed funds must be used for business or income-generating purposes. It’s not about what the loan is secured against; it’s about why the money was borrowed in the first place.
For example, if you take out a loan secured against a rental property but use the funds to buy a private residence, the interest on that loan would not be deductible. Even though the loan is tied to an income-generating asset, the funds are used for a personal purpose, making the deduction invalid.
The general rule is simple but critical—deductions depend on the purpose of the borrowed money, not the security behind it.
Redraw facilities vs offset accounts
Offset accounts and redraw facilities might seem similar, but they are treated very differently in terms of tax. The distinction between the two can make a big difference to your tax position.
Redraw facilities
With a redraw facility, any extra payments you’ve made on your loan can be "redrawn" when needed. These funds are technically a new borrowing, meaning you need to determine what the redrawn money is used for in order to understand its tax implications.
For instance, if you redraw funds to invest in shares, the interest on that portion of the loan could likely be deductible. However, if you use it for a personal expense, the interest will not be deductible.
Offset accounts
An offset account is different because the money in it is effectively treated like personal savings. When you withdraw funds from an offset account, it’s not considered borrowing, even if withdrawing increases the interest on the linked loan.
For example, if you had a mortgage for your home and withdrew money from the offset account to buy shares, you wouldn’t be able to claim any deductions since the original loan was for a private residence.
These differences highlight why understanding the tax treatment of redraw facilities and offset accounts is crucial when managing your loans.
Avoiding common traps
One of the most misunderstood issues is parking borrowed money in an offset account before using it to make an income-producing purchase. While this might seem harmless, it can create problems when trying to claim interest deductions.
For instance, if you take out a loan intending to invest in shares but temporarily deposit the borrowed funds into an offset account, you may lose the ability to claim interest deductions on the loan. The main issue is that once the money is mixed with personal savings, it becomes hard to trace and prove the funds were eventually used for income-generating purposes.
Additionally, this can have long-term tax implications. Even if the borrowed funds are later used as intended, the Australian Tax Office (ATO) may reject deductions due to the initial mismanagement of the loan.
To avoid these pitfalls, the best approach is to directly apply borrowed funds to their intended purpose without detouring through an offset account.
A tale of two cases
To better illustrate these points, here are two scenarios showing how interest is treated differently in similar situations.
Lara’s redraw scenario
Lara borrowed funds years ago to buy her home and has since made extra repayments. She redraws some of this money to invest in shares. Because the funds were explicitly redrawn for an income-generating purpose, the interest on the redrawn amount is likely tax-deductible.
Peter’s offset scenario
Peter also borrowed funds for a personal residence but deposited his extra funds into an offset account. Later, he withdrew money to invest in shares. Since offset accounts are treated as personal savings, Peter cannot claim any interest deductions.
These examples illustrate how even small decisions in managing loans can significantly impact your tax outcomes.
Why expert advice matters
Navigating the rules around interest deductions can be complex. Mistakes are often difficult to correct and can lead to long-term tax disadvantages. That’s why consulting with a tax professional is essential before making financial decisions involving loans.
A tax expert can help you structure your loans correctly, ensuring they align with your financial goals while remaining tax-compliant. They can also work with your financial adviser to develop a complete strategy for your borrowing needs.
When dealing with loans, it’s always better to get it right at the start. The costs of fixing mistakes later can be high, both financially and in terms of time and effort.
We can help
Understanding how interest deductions work is an important step in managing your finances effectively. Whether it’s determining the purpose of a loan, knowing the differences between redraw and offset accounts, or avoiding common pitfalls, being informed can save you money and stress down the line.
At the Lead Advisory Group, we specialise in helping clients make sense of complex tax situations. If you’re considering a new loan or want to ensure your current structure is optimised for tax purposes, reach out to us today.
Taking proactive steps now can ensure you’re making the most of your financial opportunities while avoiding costly mistakes.
