Expert Guide on Maximising Tax Deductions on Your Loan Interest

With interest rates set to remain high as the Reserve Bank seeks to combat inflation, the current economic environment might not look favourable for those investors who are looking to borrow to fund their portfolio. But, every cloud has a silver lining. Did you know that for every dollar extra in interest paid, the ATO will contribute up to 45 cents?

There is one basic tax rule when borrowing to fund an investment property.

• The Interest Charges on an Investment Property Loan are tax deductible, while principal and capital repayments are not.

 The tax deductibility of interest is what makes property such an attractive investment for many. This is due to the added possibility of  ‘negative gearing’ – the ability to offset losses (partly caused by those interest deductions) against other income.

Only the interest component directly related to your investment property is tax deductible. If you are paying principal and interest on your loan, you will need to calculate the interest component each year based on your loan statements. 

In addition to interest relating to the property acquisition, you can also claim a deduction for interest on loans taken out to: 

• complete renovations; 
• purchase depreciating assets (for example: furniture); or 
• make repairs or carry out maintenance.

Deductions are generally not claimed for interest on loans taken out to purchase land on which a property is to be built (i.e. vacant land). Deductions are only claimable when the property is complete, and being marketed for rent.  

Each year, the ATO focuses substantial audit activity on claims for interest deductions because so many of them are incorrect. Here are a few of the common traps and a few tips for maximising your claim.

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 investment properties. 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 rental property and the amount borrowed for private purposes.

As a general rule, 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 property and another component servicing a private borrowing (e.g. a mortgage on the family home). 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 since questioned this arrangement in court, which has meant this strategy has since become outlawed, and 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 property and her family home with her bank. She takes out an interest-only mortgage on the investment property 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).

Get the best tax outcome by paying down borrowings on your home, not your rental property

If your cash reserves are looking healthy, you may want to make the most out of that extra cash. It makes sense to pay down debt, including borrowings on properties. However, as investment property loan interest  is tax deductible and interest on your  personal home loan isn’t tax deductible, it makes much more sense to pay down the loan on your home first. 

Make sure interest claims are divided properly on jointly owned properties

Interest expenses need to be allocated amongst co-owners in line with their legal interest in the property. In the case of joint tenants (the typical scenario amongst spouses who buy together), that means 50:50. Don’t try to skew deduction claims to benefit the higher earning spouse. 

If you buy a property with others as ‘tenants-in common’ (the usual scenario where unconnected parties come together to jointly purchase a property), each owner can have unequal interests in proportion to the value of their investment. The claim for interest deductions must still be in line with whatever their legal interest in the property is, as stated on the title deed. 

If a property is in one name only but the loan is in joint names (which commonly arises where the bank requires a spouse to be a joint party to the loan in order to fund a sufficiently large borrowing), the legal owner of the property can still claim a full deduction for all of the interest. Alternatively, consider getting the other spouse to act as guarantor on the loan rather than joint borrower.

If the property is in joint names but only one name is on the loan, each joint owner can claim their share of the interest.

Example: Richard and Dawn, a married couple, purchase an investment property as joint tenants, funding the purchase through a loan that is in Richard’s name only. Despite this, both Richard and Dawn can claim 50% of the interest on the loan as tax deductions.

Additional tax tips for investment properties

• Don’t claim interest for periods your investment property is used for private purposes (such as when you spend time at your holiday home that is usually rented out)
• Don’t use any of your investment loan for private purposes, such as buying a new car or renovating your family home
• Don’t claim interest on your family home or any other property not used for income earning purposes