Optimising tax deductions
The purpose test – what determines tax deductibility
To maximise your mortgage strategy and make the best decisions today and for tomorrow, it’s important to understand what determines whether interest on a mortgage loan account is deductible or not. This is commonly known as the ‘purpose test’. Don’t be concerned if you find the purpose test difficult to fully comprehend – it is a complex area which usually takes mortgage professionals years of study to master. That said, we see it as part of our job to educate you on this.
The five key concepts are explained below.
- The difference between a ‘debit’ loan account and a ‘credit’ savings offset account is important. A debit account constitutes borrowed money. A credit or offset account does not!
- You only get one opportunity to borrow to purchase an asset, and that is when you initially purchase the property – what the borrowed money was spent on.
- The ATO doesn’t look at which loan account the money came from, but what the borrowed money was spent on.
- The property mortgaged or secured against the loan does not determine deductibility – what the borrowed money was spent on (notice a recurring theme).
- There are consequences for redrawing funds from an existing loan to fund or pay for something that is different to what the initial loan was taken out to pay for!
Understanding the purpose test will help ensure you get your mortgage strategy right from the moment of purchasing a property. It will also ensure that you do not complicate your mortgage strategy and maintain tax deductions as well as have more saving to go towards a future home or non-deductible debt. The ultimate benefit is not having to sell a property that you otherwise could have held onto.
These five common mistakes are elaborated on further. Just a heads-up that the following pages contain complex concepts that are often difficult to grasp. It is worth taking the time to wrap your head around if you plan them if you want to own multiple properties or businesses by having a conversation with your Strategic Mortgage Broker or Property Planner.
1. Difference between a ‘debit’ loan account and ‘credit’ savings offset account
Each time you repay money into a loan you can never get that debt back to claim the interest as a deduction. Whereas, if the money goes into a separate savings account that offsets the debt, you are not paying down the debt itself, despite the fact that you are still reducing the interest payable by the same amount as if you were paying down the debt. By placing the cash into an offset account, you provide yourself with the opportunity to use that cash for other purposes in the future such as funding non-deductible expenses. It also keeps the debt available for future deductions.
Property Planner’s fast fact
If your property purpose changes, then the deductibility of the related debt changes
If the purpose of the asset purchased via the loan account changes, for example your home becomes an investment property, the ability to claim the interest on that loan account will also change.
2. You only get one opportunity to borrow to purchase an asset
The only time you can borrow to purchase an asset is at the time when you pay for the asset. With this in mind, it is worthwhile considering borrowing the maximum amount achievable (as long as it fits into your affordability level), as the benefits of this strategy include:
- maintaining the maximum cash savings buffer in your bank account
- placing your cash buffer in an offset account, so you don’t pay any more interest on your mortgage than if your surplus cash had gone directly into paying down the loan account
- the extra cash available could be used towards funding non-deductible expenses in the future e.g. your long-term home
- maximising deduction on the debt could result in future benefits should the debt become deductible (e.g. your home becoming an investment property).
3. The ATO doesn’t look at where the money came from, only what it was used for
To determine if a debt is deductible, the ATO doesn’t look at where the money came from, but rather what the money was used to purchase. The key question that you need to ask yourself when determining interest deductibility on a loan is: what did the money from the loan pay to purchase, i.e. an investment property or home?
4. The property used to secure the mortgage does not determine deductibility
Often borrowers make the mistake of believing that deductibility is determined by which property is securing the mortgage. This is incorrect. Rather, the ‘purpose’ of the asset purchased with the money borrowed from the relevant loan determines whether the interest on a loan is deductible or not.
The Property Planner’s fast fact
Investment loan secured against your home
For example, Betty set up a new loan secured against her home, but the loan was used to partly fund a new investment property. The interest on this debt will be deductible because the purpose of the debt was investment.
5. Redrawing funds from an old loan for a different purpose
Many people believe they can redraw funds from an existing loan account for a different purpose than its original use and then claim the interest as deductible. This is often not the case.
The Property Planner’s fast fact
Redrawing from a loan to spend it on personal expenses is a big no-no
For example, Perce has diligently paid down his home over many years whilst living it in. He purchases a new home and rents out his old home. As such, his old home is now an investment property. To purchase his new home, Perce redraws from the original mortgage loan (on his old house). This loan is now a mixture of deductible ‘good’ debt used for the old home (now investment) and non-deductible ‘bad’ debt used to purchase the new home. However, Perce claims all the interest from this loan against his investment property as a deduction when he completes his tax returns. This is a mistake and will fall foul of the ATO as it fails the ‘purpose test’.
The fine details cost big time
Limits, balances and redraw!
Many people inadvertently damage their mortgage strategy because they do not understand the Purpose Test. Unfortunately, most lenders and mortgage brokers do not understand this either, let alone ask you all the questions needed to unpack your strategy. They do not have a Private Banking team that ensures all your loan balances and offset account are drawn down accurately at settlement. The mainstream banks take no care to ensure that loans are drawn down with the correct loan balances either. No wonder almost every accountant I have met pulls their hair out when it comes to confirm borrowers’ tax deductions accurately and trying to follow the money trail! Below we define some pitfalls that people get into (and want to educate you to avoid).
David is the Founder and Managing Director of Property Planning Australia, author of ‘How to Succeed with Property to Create your Ideal Lifestyle’, co-author of ‘Property for Life – Using Property to Plan Your Financial Future’, co-host of the ‘Property Planner, Buyer and Professor Podcast’ and a widely-published media commentator. With more than 20 years of experience, David is passionate about educating others to make informed, and ultimately, more lucrative property investment decisions. David established Property Planning Australia in 2004 – with the vision to educate and empower Australians to make successful property, mortgage strategy and money management decisions. Property Planning Australia’s operations have earned acclaim and national industry awards for its unique fusion of property planning, education, money management, mortgage strategy and risk management. All supported by multi award-winning customer service.