The basic tax rule when borrowing to fund an investment property is that interest charges on a loan to acquire an investment property are tax deductible while principal or capital repayments are not.
The tax deductibility of interest is what makes property such an attractive investment for many because it is a key component in ‘negative gearing’ – the ability to offset losses (partly caused by those interest deductions) against other income.
Only the interest component directly related to your investment property is tax deductible. If you are paying principal and interest on your loan, you will need to calculate the interest component each year based on your loan statements.
In addition to interest relating to the property acquisition, you can also claim a deduction for interest on loans taken out to: carry out renovations; purchase depreciating assets (for example, furniture); or make repairs or carry out maintenance.
You generally cannot claim a deduction for interest on loans taken out to purchase land on which a property is to be built (ie, vacant land) until the property is actually complete and being marketed for rent.
Each year, the ATO focuses substantial audit activity on claims for interest deductions because so many of them are incorrect. Here are a few of the common traps plus a few tips for maximising your claim.
Don’t mix investment and private borrowings
It’s common for financial institutions to offer redraw facilities against existing loans, which investors sometimes use to purchase investment properties. Such a redraw may be used for income-producing purposes, non-income-producing purposes or a mixture of the two. In the latter case, the interest on the loan must be apportioned between the deductible and non-deductible components, with the split reflecting the amounts borrowed for the rental property and the amount borrowed for private purposes.
As a general rule, try to avoid mixing loan accounts that have both deductible and non-deductible components since it can be difficult to correctly work out the split.
In the past, so-called “split loans” were popular, whereby a loan was taken out with one component servicing an investment property and another component servicing a private borrowing – a mortgage on the family home, for example. It was therefore possible to channel all the cash repayments against the private borrowing (where the interest is not tax deductible) while maintaining a growing balance on the investment part of the loan (where the interest is deductible). The ATO has challenged such arrangements in the courts and that strategy to minimise tax is no longer allowed.
However, it is possible to take out two loans with the same financial institution, each maintained independently: one in relation to the investment and one in relation to the private property. By making greater repayments against the private loan, a similar tax outcome can be achieved as with the split-loan scheme but at much lower tax risk.
Example: Barbara refinances her investment property and her family home with her bank. She takes out an interest-only mortgage on the investment property and pays the minimum necessary to meet her commitments to the bank. She takes out a principal-and-interest mortgage on the family home and maximises her payments every month in order to reduce the principal outstanding (and hence, over time, reduce the non-deductible interest payments).
Get the best tax outcome by paying down borrowings on your home, not your rental property
If you’ve escaped the COVID-19 pandemic without losing your job or business, it’s possible that your cash reserves may be looking a lot healthier than usual, what with limited opportunities to spend on travel, recreation, take-away coffees, etc. If you want to make that cash work for you effectively, it makes sense to pay down debt, including borrowings on properties. However, as interest on loans that relate to investment properties is tax deductible and interest on your home loan isn’t tax deductible, it makes much more sense to pay down the loan on your home first.
Make sure interest claims are divided properly on jointly owned properties
Interest expenses need to be allocated amongst co-owners in line with their legal interest in the property. In the case of joint tenants (the typical scenario amongst spouses who buy together), that means 50:50. Don’t try to skew deduction claims to benefit the higher earning spouse.
If you buy a property with others as ‘tenants-in common’ (the usual scenario where unconnected parties come together to jointly purchase a property), each owner can have unequal interests in proportion to the value of their investment. The claim for interest deductions must still be in line with whatever their legal interest in the property is, as stated on the title deed.
If a property is in one name only but the loan is in joint names (which commonly arises where the bank requires a spouse to be a joint party to the loan in order to fund a sufficiently large borrowing), the legal owner of the property can still claim a full deduction for all of the interest. Alternatively, consider getting the other spouse to act as guarantor on the loan rather than joint borrower.
If the property is in joint names but only one name is on the loan, each joint owner can claim their share of the interest.
Example: Richard and Dawn, a married couple, purchase an investment property as joint tenants, funding the purchase through a loan that is in Richard’s name only. Despite this, both Richard and Dawn can claim 50% of the interest on the loan as tax deductions.
Some more do’s and don’ts
- Don’t claim interest for periods your investment property is used for private purposes (such as when you spend time at your holiday home that is usually rented out)
- Don’t use any of your investment loan for private purposes, such as buying a new car or renovating your family home
- Don’t claim interest on your family home or any other property not used for income earning purposes
By Mark Chapman, Director of Tax Communications, H&R Block