With interest rates currently set to remain at a high level for the rest of the year as the Reserve Bank seeks to combat inflation, the economic environment might not look favourable for those investors who have to borrow to fund their portfolio. But every cloud has a silver lining writes Director of Tax Communications at H&R Block, Mark Chapman.
Did you know that for every dollar extra in interest that you have to pay, the taxman will contribute up to 45 cents?
This happens because interest incurred on earning taxable income is deductible against your taxes. Investment income is taxable income. That means the more interest you pay to fund your portfolio, the bigger the tax deduction.
If you are paying tax at the highest individual rate, that can mean you get relief for all of your tax deductible interest payments at up to 45%.
Of course, only the interest component directly related to your investments is tax deductible. If you are paying principal and interest on your loan, you can’t claim a deduction in relation to the principal element. Thankfully, this portion of the loan should stay relatively constant (if you have an interest-only loan) or even go down as you pay the loan off (unless you borrow more!).
You will need to calculate the interest component each year based on your loan statements or alternatively your bank will advise you of the amount of interest paid immediately after the end of the tax year.
Some other tips for arranging your loans to maximise interest deductions are:
1. 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 further investments. 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 investment 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 facility 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 portfolio and her family home with her bank. She takes out an interest-only mortgage to fund the investment portfolio 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).
2. What if my investments don’t pay a return in the year?
Even if the investments don’t pay a return (for example, your shares don’t pay dividends) in a particular year, it is still possible to claim the interest on the borrowings so long as there is a reasonable expectation that the shares will generate assessable income over time.
In addition, you can argue that the shares are being held for capital growth over the long term, which on sale (possibly several years down the track) will yield capital gains, which counts as assessable income. Therefore, it isn’t necessary to generate some (or indeed) any returns in the form of dividends in between.