One of the most important elements of getting your own loan structuring right is to avoid debt pollution. Simply put, this occurs when the purpose of your debt is not clear from a tax perspective resulting in inefficiencies when it comes to tax deductibility. An example of this would be where you’ve set up a Line of Credit against an existing investment property and used 80% of it to purchase another investment property and 20% to purchase a car for your personal use. We’ll highlight the issues with this and how to avoid such traps as we progress.

Let’s start with the basics

Under the Australian Tax Office (ATO) guidelines, the interest paid on a loan is generally tax deductible where the purpose of the loan is to generate Australian assessable income. An example of this would be securing a loan to purchase an investment property in Australia that you intend to rent out. The rent becomes Australian assessable income and therefore the interest paid on the loan is tax deductible.

There are many cases where the loan would not be considered tax deductible such as the purchase of personal use assets, or even purchasing an investment property that you don’t rent out. Because there is no assessable income being produced by way of rent, generally the interest paid on the loan would not be tax deductible.

Now that we’re clear on when the interest paid on a loan is and isn’t tax deductible, let’s consider some common traps that many people can find themselves in. Most of these issues are caused by Line of Credit or Equity Access loans, where confusion about the purpose of the debt can be created.

Let’s take a look at 3 case studies

Case Study #1 

Mary has owned an investment property in Sydney for some time now and thanks to recent price growth, she has equity in the property that she wanted to utilise to expand her portfolio. With the assistance of her mortgage broker, she set up a Line of Credit for $250,000 with her lender of choice. Mary decided to utilise $200,000 of this loan to cover the deposit and purchase costs of a new investment property that she purchased for $800,000 securing a new loan for 80% of this new property. She then decided that she would like to upgrade her car with the remaining $50,000 of the Line of Credit.

The issue for Mary here is that she ‘polluted’ her Line of Credit when it comes to the purposes of the debt. $200,000 of the loan is tax deductible and $50,000 is not based on how she has directed these funds. To make matters worse, generally the ATO will regard this situation as having any repayments reducing the non-deductible debt first (reducing the $50,000), and therefore, until the $50,000 is fully repaid, none of the interest paid will be considered tax deductible.

Case Study #2 

John currently owns two properties in Brisbane, one of which he lives in as his primary residence, and the other is his investment property which is currently rented out. He has owned his investment property for some time now and thanks to climbing rent, he has significantly reduced his investment loan while the mortgage on his own home has not been reduced as much as he would like. John decides that he will utilise the funds available for redraw on his investment property and reduce the mortgage on his own home under the assumption that these funds will become tax deductible.

Unfortunately for John, the purpose of this redraw is not for investment purposes as he’s using the funds to reduce the debt on his own home, which is clearly not used to produce Australian assessable income. Even though he’s shifted funds from one place to the other, he hasn’t improved the tax efficiencies of his loan structures.

Case Study #3

Susie and Max own 3 properties in Melbourne, one of which is their own home and the other two are investment properties that are rented out. Some time ago they set up an Equity Access Loan to fund the deposits and purchase costs of the two investment properties. To make matters simpler for themselves, they decided to have their salaries paid into the Line of Credit account and then use these funds when required to pay for their personal living expenses.

The issue for Susie and Max in this case, is that they’ve altered the purpose of the Line of Credit. They are slowly changing the purpose of this loan to personal use as they’re drawing funds from the account to pay for their personal living expenses. Not only has this reduced the tax efficiencies for them, it’s also made the matter incredibly messy to try and not only track, but prove to the ATO, what is tax deductible and what is not.

What are the solutions for each case study?

With prior planning at the start and obtaining the right advice, each of these situations can be avoided. In Mary’s case where she wanted to upgrade her car as well as purchase an investment property, one option would have been for her to establish two separate loan accounts. One would be for the purpose of the investment property and the second for the purchase of her vehicle. Not only would this be much clearer for the ATO which is tax deductible and which is not, but it will also allow her to self-direct any repayments made and therefore control her own tax efficiencies.

In John’s case where he is trying to shift funds from one loan account to another, a better option would have been to redirect surplus rental income to repaying the loan on his primary residence. He should also look at refinancing options for his investment property to reduce the interest rate and therefore the repayment amounts. This allows him to reduce the loan on his primary residence faster while maintaining the tax efficiencies of his investment loan.

For Susie and Max, they should have their salary paid into a separate account, perhaps an offset account rather than straight into the Line of Credit. They could then use some of the funds here to cover their personal living expenses and direct the remainder into their Line of Credit if they wish to do so. This avoids polluting their debt and ensures that the purpose of the loan is clear.

As you can see, there are many ways that you can unintentionally impact your own personal financial situation. Ensure that you receive the right advice and avoid any debt pollution traps and pitfalls.


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