In response to COVID-19, at least one major national lender has reduced scheduled minimum home loan repayments with retrospective effect. Borrowers who are ahead on their loan may then have the ability to redraw excess repayments.
For an investment loan, redrawing for private or domestic purposes will render part of the loan interest non-deductible. To cure the problem, a cumbersome refinancing strategy would be required.
To maintain full interest-deductibility on an investment loan, redrawing for private or domestic purposes should be avoided. Instead, the value of excess repayments may be accessed over time, via a reduction to (or pausing of) monthly repayments, for any purpose without affecting deductibility.
How Redrawing Can Affect Interest-Deductibility
A common misconception is that home loan interest deductibility is determined by the type of property used as security for the loan. This is incorrect. Where a taxpayer borrows to buy an investment property, the interest is deductible not because an investment property is used as security, but because the borrowed money is used to acquire an income-producing asset.
If a taxpayer redraws on an investment loan, and uses the redrawn money for private or domestic purposes, interest deductibility will be apportioned on the basis of the uses to which the total borrowed funds have been applied. For example, if the redraw results in 10% of the total outstanding balance having been used for private or domestic purposes, then after the redraw only 90% of the interest on the loan would be deductible:
|Total amount borrowed||Amount borrowed for income-producing purposes||Amount borrowed for private or domestic purposes||Deductible proportion|
|Prior to redraw||$450,000||$450,000||$0||100%|
|After redraw of $50,000 for private or domestic purposes||$500,000||$450,000||$50,000||90%|
If the redrawn amount is later repaid (or the entire loan is refinanced with a single new loan), this will not fix the problem. This is because repayments are apportioned on the same basis as the borrowings. In the above example, it is not permissible to allocate the whole of a repayment to the private or domestic balance. Instead, only 10% of each repayment would relate to the non-deductible balance, and the deductible proportion of the loan would remain unchanged.
The only cure would be to refinance the existing mixed-purpose loan with two new loans. For example, if the above loan totalling $500,000 were refinanced with two separate loans in the amounts of $450,000 and $50,000, the Commissioner of Taxation should accept that interest on the new $450,000 loan is fully-deductible (see Taxation Ruling TR 2000/2 at paragraph 25). This should be unaffected by the repayment of the separate $50,000 loan.
Improving Cashflow Without Redrawing
It is possible for an investment loan borrower to access the value represented by excess repayments without redrawing. Instead, monthly repayments can be reduced (or paused) until the outstanding loan balance realigns with the scheduled balance. Because this does not change to the use to which the borrowed money has been applied, interest deductibility is unaffected. The downside is that the cash flow benefit of the reduction in repayments may be spread over multiple months.
If you have any questions about the tax implications of redrawing on your investment loan, please contact a member of Thomson Geer’s Tax Advocacy Team.
Jeffrey Chang | Partner | VIC | +61 3 8080 3574 | [email protected]