One of the most common financial steps people go through involves buying a new family home which is of a better standard than their last one. This is a natural progression as people settle into careers, have more disposable income and build families.
Often people decide to keep the previous property as an investment and use the rental income to assist with repaying the larger debt and building wealth. There is a trap with this scenario that can lead to a poor taxation outcome, and effectively make repaying the debt take significantly longer due to the limited assistance from the tax man.
The issue is whether the interest on a loan is tax deductible or not. If you are earning between $45,000 and $135,000 and are paying 32% as your marginal tax rate, roughly a third of your interest is covered by the tax man if your debt is tax deductible. If you are borrowing at, say 6% for both your non-tax-deductible home loan and your tax-deductible rental property loan, you are effectively only paying 4% on the rental property loan after tax. The more of your debt that is allowed to be claimed as tax deductible the better. In this scenario it’s important you separate the debts so you can easily identify the interest and what you are paying off each debt. Ideally you want to pay off the non-tax-deductible debt first before moving on to the tax-deductible debt.
Contrary to what many people think, the key to whether a loan’s interest is tax deductible or not is not which property is used to secure the loan. The key is what the money was used to purchase when the loan was drawn down and not which property the bank takes a mortgage over. Generally, the family home doesn’t produce income and therefore loans used to purchase Principal Places of Residence are not tax deductible even if you used equity in the old home to borrow. Loans for rental properties or shares generally are tax deductible and therefore minimising the loan required to buy the new family home and consequently increasing the investment loan makes sense. Often selling the old home, maximising the cash deposit on the new home and using the equity to borrow to buy a new investment makes more sense. As always the devil is in the detail and it needs careful analysis of sale and purchase costs and each person’s tax situation to make the right decision.
There are several strategies that can be used to decrease non-deductible debt and replace it with deductible debt and investments, and a range of flexible lending products to assist. As always seeking the advice of a knowledgeable Financial Adviser, Accountant and Mortgage Broker is advisable.
For a free consultation with local people who understand the complexities of these or any other financial matter, contact Eclipse Financial Planning at Cannonvale on 49467359 today or visit www.eclipsefp.com.au
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