One of the most common questions we get from our clients is how they can pay off their home loan faster and reduce their non-deductible debt.
If you are not asking yourself these questions, here is why you should.
Normally, the interest you pay on your home is not tax deductible. In some cases, where your home is used for income producing purposes, a portion of the interest on your home loan may be deductible. However, there may also be capital gain tax on a portion of the gain from the sale of your home in this case. For simplicity, this article will assume your home is not used in any way for income producing purposes.
For most medical practitioners, their marginal tax rate is 47% (including Medicare levy). This means that when paying non-deductible interest on your home loan, their actual pre-tax cost is almost double. For example, for every $1 after-tax you pay for your non-deductible home loan, you need to earn $1.89 (pre-tax amount assuming a 47% marginal rate).
Another way to look at it is using the interest rate you are paying on your loan. If your non-deductible home loan interest rate is 5.5% p.a., your investment will need to generate a return of 10.38% p.a. pre-tax to cover your home loan after tax and the return on your investment isn’t guaranteed. The bottom line is non-deductible debt is expensive.
Debt recycling is essentially a strategy that focuses on converting non-deductible (home) debt to tax deductible (investment) debt while building wealth.
Some of the key fundamentals of such a strategy are:
- The overall level of debt is not necessarily reduced but converted from a non-deductible (home) loan to a tax deductible (investment) loan.
- For interest to be tax deductible, there must be a direct link between the purpose of the loan and an income producing asset.
- There needs to be a clear separation between the non-deductible loan and the tax-deductible loan to ensure the purpose of the loan is not tainted for tax purposes.
- Use time to your advantage –the sooner you start, the more impact this strategy may have on your personal wealth.
Consider the following case study:
- Your home is valued at $1,250,000
- Your non-deductible home loan is: $1,000,000
- The interest rate is 5.5% p.a.
- Your loan term is 10 years paying principal and interest
- Your monthly repayment is $10,852.63
After the first 12 months
- Your total repayments were just over $130,000
- You paid just over $53k in non-deductible interest
- Your home loan balance is roughly $923,000 and your equity increased by $77,000
Using a debt recycling strategy, you could then use the equity to borrow $77,000 and invest that amount in income producing assets to ensure the interest on that new loan is tax deductible. Assuming you repeat this strategy over the 10 years of your loan and you also use the income from your investment portfolio (after tax) to accelerate the repayments of your home loan.
This is a key point, as the portion of non-deductible interest payment in the first few years of your home loan is very high. The quicker your home loan balance is reduced, the less non-deductible interest you will have to fund. Furthermore, additional repayments towards your non-deductible home loan mean you will pay off your home loan quicker.
There are, however, a few things to consider
- You will have to liaise with your bank to ensure appropriate facilities are available. Movement of available funds from an offset account does not qualify as a new investment loan for tax purposes. It is advised to establish a separate new loan facility that is dedicated to income producing purposes for the interest to be tax deductible.
- Appropriate documentation must be kept supporting the deductibility of interest.
- Your investment portfolio may be subject to market movement.
- This strategy works better when the investment is income producing rather than investment in capital growth assets.
- Changes in interest rates can impact the results of this strategy.
- Be aware that the ATO may be critical of arrangements where you artificially create deductible debt in your practice while diverting practice income to reduce your non-deductible debt.
We highly recommend that you speak to your accountant and wealth advisor before implementing such a strategy so that you are aware of all aspects that can affect you.
There are also other scenarios where your existing structure may present an opportunity for debt recycling. If you previously funded your practice and lent money to it in its initial stages, there may be an opportunity for the practice to introduce external debt to repay you for such a loan. Subject to your individual circumstances, the repayment of the loan to you may not be subject to tax and you could use the funds to reduce your non-deductible debt.
Other opportunities may exist as part of an overall succession planning for your practice if a restructure is needed to facilitate the introduction of new business owners to your practice. Careful consideration is needed in such cases, as many taxation aspects are involved and the results may vary based on your individual circumstances. Subject to the availability of specific tax concessions, you may be able to introduce tax deductible debt to your practice while allowing you to reduce your non-deductible debt outside of your business structure.
If you’d like help and if debt recycling as a strategy might be suited for you, contact your local William Buck advisor.
