Interest deductibility and investment properties
With interest rates remaining stubbornly high, and some property investors bailing out altogether, others are taking steps to refinance their debt in order to secure a lower rate and obtain better terms.
Before deciding to go down the refinancing route there are broader financial issues to weigh up and you may need to seek separate financial advice that takes into account your personal and financial circumstances. This article only examines the tax consequences of refinancing your investment property loan and some other issues around interest deductibility.
Basic rule for interest deductibility
The basic rule is that where you borrow money to acquire an income producing asset, the interest is deductible against your assessable income generally, including income from salary and wages. It’s about following the money and being able to demonstrate that a loan was used for income producing purposes. Any security given over a loan does not determine the deductibility of the interest.
Maximising tax deductible debt
There is nothing improper or untoward about maximising your tax deductible debt. We live in an after tax world and it’s perfectly legitimate to factor tax into your financial decision making.
Lower rate on refinancing
Where the refinancing involves no more than obtaining a reduced rate or better terms, there has been no additional borrowing and the interest on the new loan remains deductible in full, assuming the property is let or available to let.
Releasing equity
Where the refinancing releases equity in the investment property, interest deductibility depends on how the additional loan funds are applied. If they are used to maintain or renovate the investment property (or to buy other income producing assets), all the interest payable on the increased loan balance will be deductible.
However, where all or part of the equity released is applied for private purposes (like renovating the house you live in, to pay for a holiday or to buy a car), the interest would need to be apportioned between the amount originally used to acquire the investment property (deductible) and the amount used for private purposes (non-deductible).
Refinancing costs
Refinancing costs for the investment property such as exit fees, valuation fees, break costs and legal fees are deductible over five years or the term of the new loan if that is shorter.
Change in use
What if there is a change in use of the investment property? You might decide to move into the property yourself or to make it available to a family member free of charge. As soon as the investment property stops being used to generate rental income, the interest associated with the loan taken out to acquire the property stops being deductible.
By the same token, if you move out of your main residence to go and live somewhere else and you put tenants in, any interest on the mortgage over the property will become deductible.
Debt in the wrong place
Sometimes, through circumstances beyond your control, you can end up having debt in the wrong place. For example, you may have a mortgage over the house you live in and inherit the house of a relative which is unencumbered by debt. If you decide to keep the inherited property and put tenants in, you will have non-deductible home mortgage interest as well as an investment property that is debt-free.
While you could borrow using the inherited property as security and use the funds to pay off your home mortgage, that would not get you a tax deduction, as the borrowed funds would have been used to pay off private debt. Remember, it’s the use to which the funds are put that determine tax deductibility – not the nature of the security provided. The only way to make the interest tax deductible in this situation would be through a change in use. For example, you may decide to move into the inherited property and let out your main residence.
Forced sale
Real estate values can go down as well as up, and sometimes life’s events (rising interest rates, unemployment, illness, divorce) can leave the property owner with no other option but to sell the property, sometimes with part of the borrowing remaining unpaid. Any interest on the outstanding balance would generally be tax deductible, although the ATO would expect the investor to make a reasonable effort to pay down the remaining debt rather than acquire more assets.
Before deciding how to refinance an investment loan or taking any other steps that could impact on the tax deductibility of interest, come in and have a chat with us. We may be able to help you protect the interest deductibility you are legitimately entitled to.
