Individuals earning and being taxed via the PAYG system are finding that the ATO has done away with a lot of the rules that once allowed opportunities for tax savings. One of the few remaining strategies available to minimise tax is to claim interest as a tax deduction. To help you stay on top of your game, we’ve compiled a list of common pitfalls you need to avoid when borrowing.
Negative gearing: borrowing to invest
You’ve probably heard the term ‘negative gearing’ used in relation to investments. ‘Gearing’ is just another term for ‘borrowing’, and depending on the structure of your finances, investments may be geared positively, neutrally or negatively.
A positively geared investment produces more income than it’s costing you in interest. The opposite is true with negative gearing – the cost of the loan is higher than the income the asset is producing. Why would you choose to structure an investment like this? Simple: any shortfall incurred in this way is tax deductible, meaning the ATO will cover up to 47% of the cost, depending on your marginal tax rate.
This only applies to loans used directly to buy an income-producing asset (e.g. property or shares) which adds to your annual taxable income. Money used for superannuation contributions or insurance bonds, therefore, is not included.
It’s important to understand this, otherwise you could end up in a situation where you’ve borrowed money with a loan on which the interest is non-deductible, and the funds you’ve invested won’t be accessible for another 30 years.
When determining whether loan interest is tax deductible, the ATO will examine the purpose of the borrowing rather than the asset mortgaged.
One common scenario where this can cause issues is if you have a low debt on your home and you decide to move to a new place and rent the old one out. The loan on your new home isn’t eligible for a tax deduction, even if you secure it against the existing property, because it’s being used to purchase a new residence rather than an investment.
In this case, it’s generally better to sell the original property (which will incur no CGT) and purchase the new one with a minimal loan. Then, any loans you take out to purchase additional property as an investment (or to invest in shares) will be tax-deductible.
Find out more about other costs associated with an investment property which are tax deductible.
Borrowing for the right purpose
It’s not just with mortgages that it’s easy to trip up. If you take out a loan and can’t clearly show that the money redrawn has been used to fund your investments, the ATO may refuse your claim for a deduction and hit you with additional penalties. In one well-documented case a woman was fined 25% of the claim because she didn’t have sufficient evidence.
Line of credit loans can also present a potential borrowing trap as they are not typically assigned to a particular purpose and can be accessed by the borrower in small amounts as and when needed. Again, the interest on this type of loan will only be tax-deductible if you can show that the money has been used directly for an income-producing asset.
As an example, let’s say that Matt and Sandra own their home outright and take out a $200,000 line of credit loan for an investment property. To reduce the amount of interest on the loan, they put their salaries directly towards paying it off and then use their credit cards (which offers a fixed interest-free period) for day-to-day living. When the payment is due on their cards, they use the loan to cover the cost.
Because they are using the loan to make payments for private credit card purchases, even though it originally funded the investment property, the interest will not be treated as tax-deductible by the ATO. To benefit from a tax deduction on the loan interest, Matt and Sandra would have to use a portion of their salaries to repay the principal while keeping enough money aside to cover day-to-day living.
Capital gains tax events
Many people are still in confusion regarding capital gains tax (CGT), particularly when it comes to giving property or shares to family members. Just because no money changes hands, it doesn’t mean that no CGT is due. Aside from your family home, which is exempt from CGT, the disposal of any asset – whether or not sold for cash – will trigger a ‘CGT event’ which means you are liable for paying tax on any gain during the time you have held the asset.
Where an asset is passed on to a family member, the ATO will treat it as a sale at the current market value. This could result in a hefty tax bill if the value has risen considerably while you’ve owned it, so make sure you’re aware of the implications before you make any such transfer.
Borrowing pitfalls summary:
- Claiming interest as a tax deduction is one of the few remaining ways for individuals to minimise tax when borrowing, but it must be done correctly for the deduction to be allowed
- When the cost of interest on a loan used to purchase an asset outweighs the value of any income, we say the investment is ‘negatively geared’ and the shortfall may be claimed as a tax deduction
- This is only true if the loan was used directly to purchase an income-producing asset which will add to your taxable income (so superannuation and insurance bonds are excluded) and if you have sufficient evidence to show what the money was used for
- Capital gains tax applies to disposal of assets even if you give them away to a family member, so make sure you know how much tax you’ll be liable for before you take any action