It’s a simple, step-by-step process used by many Australians to increase their income. Borrow money from a financial institution, invest in a second property and pay off the loan with the profit accrued from the investment property (ie. rent from tenants).
But did you know that the interest on a home loan for the purchase of an investment property can be claimed as tax-deductible?
To clarify – claiming a tax deduction on the interest of a loan can only be used on the loan that was used to purchase the investment property. It also must be used to earn income, because a property that is solely residential isn’t eligible for any tax deductions (except in certain situations where the residence may be used to produce income, like home business or office).
Here are a few examples of when tax deduction claims on your property are not allowed:
- If the secured property is being used for living as a primary residence, and no income is made from it.
- Refinancing your investment loan for some other purpose (like buying another property).
- Using the loan for private purchase, other than the purchase of a home.
- If the investment property is a holiday home that is not rented out, then deductions cannot be claimed as it doesn’t generate rental income.
As an example, if borrowing against your main residence for the purpose of purchasing an investment property, then the interest on that loan is tax-deductible. Conversely, if the loan was against the investment property to buy a car for your personal use, then the interest from that loan will not be tax-deductible.
The only way that a tax deduction on a home loan’s interest is possible, is if there is a direct, unbroken relationship between the money borrowed and the purpose the money was used for. Any money that resulted from a home loan, for instance, should have been invested into a property.
If you happen to redraw (make extra repayments into your loan that reduce the loan balance) against an investment loan for personal use, the tax-deductible interest is watered down. This is because the new drawdown (transfer of money from a lending institution to a borrower) is deemed to not be for investment purposes.
It is important that any investment loans are quarantined from your personal funds to maximise tax deductions on interest. Though it may be tempting to pull additional funds from the loan for additional finances, it’s shooting yourself in the foot.
A better strategy (if there is only investment debt that has been incurred, and you wish to pay it off), is to place funds in an offset account (a bank account that is linked to your home loan) and then redraw those funds for your personal use. It’s also important to ensure that the offset account is a proper offset – a redraw that is disguised as an offset account can be a major drawback for investors looking to capitalise on their tax threshold.
If you or someone you know has recently purchased an investment property with a home loan, speak to your accountant or financial advisor to see how your tax return can benefit from it.