Debt Recycling
Debt recycling is the act of turning non-deductible debt, such as your home loan, into deductible debt. On a $1m home loan, this could cut tax by about $25k a year.
When you borrow funds to generate an assessable income with, such as buying a rental property or shares, the interest charged on the loan is tax deductible. The ATO considers that all named parties on the loan have equal portions of deductibility.
Example: $100k debt recycling
| Step | Current | Lump sum | Redraw |
|---|---|---|---|
| Cash | 100 | 0 | 0 |
| Investment | 0 | 0 | 100 |
| Loan Balance | 150 | 50 | 150 |
| Interest Rate | 6% | 6% | 6% |
| Interest Payable | 9 | 3 | 9 |
| Deductibility | 0% | 0% | 67% |
| Tax Rate | 47% | 47% | 47% |
| Tax Reduction | 0 | 0 | 2.8 |
Each time you draw funds from a loan account you need look at what you did with those funds to determine the purpose. When you repay the deductible percentage does not change as it is considered that you pay off both deductibe and non-deductible portions of the loan. When you redraw the deductible value increases.
Example: Loan purpose impact on deductibility
| Step | Purpose | Repayments | Borrowings | Loan Balance | Deductible % | Deductible $ |
|---|---|---|---|---|---|---|
| 1. Draw Down | Home | - | 100 | 100 | 0% | 0 |
| 2. Lump Sum | - | 10 | - | 90 | 0% | 0 |
| 3. Redraw | Invest | - | 10 | 100 | 10% | 10 |
| 4. Repayments | - | 20 | - | 80 | 10% | 8 |
| 5. Lump Sum | - | 20 | - | 60 | 10% | 6 |
| 6. Redraw | Invest | - | 20 | 80 | 33% | 26 |
| 7. Holiday | Personal | - | 10 | 90 | 29% | 26 |
| 8. Release Equity | Invest | - | 50 | 140 | 54% | 76 |
In the example the steps work as follows:
- Borrow $100k to buy a home to live in, none of which is deductible.
- Repay $10k of the loan, using excess cash or sold shares.
- Redraw $10k from the loan to invest in shares, now 10% of the interest is deductible.
- Standard repayments over years reduce the loan by $20k, 10% is still deductible, but that's reduced to $8k.
- Lump sum repayment of $20k reduces the loan by $20k, 10% is still deductible, but that's reduced to $6k.
- Redraw $20k from the loan to invest in shares, increasing deductible to $26k, now 33% of the interest is deductible.
- Personal use of $10k increases the loan by $10k, reducing the overall deductibility to 29%.
- Redraw $50k from the loan to invest in shares, increasing deductible to $76k, now 54% of the interest is deductible.
Strategies
You need to avoid doing lump sum repayments on loans which have a non-deductible portion. If you have a loan that is 50% deductible of $100, paying down $20 would result in 50% deductible on a $80 loan. When you redraw the $20 the deductible amount increases from $40 to $60 so overall you debt recycled $20 and only got a $10 benefit from it.
- Split loan accounts before you pay down so when you redraw it is always from a loan which is 0% deductible.
- Investing in income producing growth assets (property or shares) can result in negative gearing for the borrowers.
- Lending to a family trust or company can allow you to stream excess returns to low income family members. Only beneficial if the investment inside the trust can return more than the commercial rate you have to charge for a trust loan.
- When interest rates are low use fixed interest loans from your trust at commercial rates for 20 years. When interest rates rise this may result in negative gearing.
- If on a principle & interest home loan, loan your family trust using a P&I loan with the same term so the principle reduces together. You can release equity later and purchase other assets.
- If you have two loans - a non-deductible home loan and a deductible investment loan - the investment loan will generally be at a higher interest rate. While you should normally pay down the higher rate loan first, debt recycling produces the best outcome: 1) Repay the home loan, 2) Redraw from the home loan, 3) Use the redraw to repay the investment loan. This converts non-deductible debt to deductible debt while eliminating the higher interest rate.
Key Requirements
- Cash movement must be traceable and recorded. Don't mix your personal and investment funds.
- Investment must be on commercial terms. Don't loan your cousin the money at 0%.
- Investment must produce assessable income. Don't invest in a collectable or bitcoin as they don't produce assessable income.
- All parties on loan must benefit from income. Don't invest only in your name, make sure the investments are in the name of both parties or each party invests in the same proportion they are on the loan documents (usually 50/50).
Simulator
10-Year Debt Recycling Benefit
| Year | Deductible Amount | Deductible Interest | Tax Benefit | Cumulative Benefit |
|---|---|---|---|---|
| 1 | $100,000 | $5,000 | $2,350 | $2,350 |
| 2 | $100,000 | $5,000 | $2,350 | $4,935 |
| 3 | $100,000 | $5,000 | $2,350 | $7,779 |
| 4 | $100,000 | $5,000 | $2,350 | $10,906 |
| 5 | $100,000 | $5,000 | $2,350 | $14,347 |
| 6 | $100,000 | $5,000 | $2,350 | $18,132 |
| 7 | $100,000 | $5,000 | $2,350 | $22,295 |
| 8 | $100,000 | $5,000 | $2,350 | $26,874 |
| 9 | $100,000 | $5,000 | $2,350 | $31,912 |
| 10 | $100,000 | $5,000 | $2,350 | $37,453 |
FAQ
That depends on the interest rate charged by the bank for being interest only, the type of investment you make, and your cashflow. P&I usually has a lower interest rate, and you can refinance and redraw to unlock more equity regularly.
No, ATO v Hart (2004) confirmed that capitalising interest, which increases the deductible loan portion, is seen as having a dominant purpose of obtaining a tax benefit and therefore Part IVA (general anti-avoidance rule) applied.
No, the loan is only deductible if it produces income for the person claiming the deduction.
Yes, it needs to be a commercial investment. So if you loan the money to a family member, company or trust you need to have a loan agreement just like you would if you loaned it to a stranger.
No, the principle on the loan must be paid down and then redrawn or a new loan taken out. An offset account is more like a savings account where the interest rate is the same as the loan rate.
No, it's best not to as this can taint the loan purpose and make the loan non-deductible. If you must do this then split the loan so you don't mix purposes.
Yes, as long as its done in a timely manner and you can show that the cash moved from asset to asset. Usually it is best to pay down the loan and redraw so the purpose refreshes and remains clear. At the very least you need to ensure that the current balance of the deductible loan is invested again as soon as possible; do not let it mix with your private funds.