Chapter 6 - Don't mix your debts
Prioritising the repayment of non-deductible debt
Often, an investor who is making use of negative gearing will also have borrowed money for some private purpose, such as buying the house they live in, or a personal loan, or a private credit card.
It is very important that the debts are kept separate in this situation. Separate loan accounts, perhaps even with separate lenders or with the loans held in different names, are very useful.
The reason for this is that the tax-deductible nature of interest on investment debt (‘investment interest’) makes it cheaper than non-deductible interest that is being charged at the same interest rate. So, an investor paying 5% on both a private home loan (non-deductible interest) and an investment property loan (deductible interest) is actually paying something less than 5% on the investment loan. If the investor’s marginal tax rate is 30%, for example, then the effective interest rate is 30% less than 5%, or 3.5%.
Where these two types of debt co-exist, then, it makes sense for all repayment efforts to be dedicated to repaying the more expensive loan first. This will typically be the private debt.
At the same time, it makes sense to use borrowed money to pay any expense for which interest on borrowed money would be deductible. By borrowing the money for these expenses, you free up as much of your cash flow as possible to be used to pay down the non-deductible debt.
AMP refer to this as ‘debt recycling’ and you can read their thoughts on it here. As it happens, ‘debt recycling’ is a misnomer. The debt is not recycled. One debt is removed and another is created. They are two different debts. The second debt is entirely new. But let’s not quibble – the AMP is better at developing strategies than it is at naming them.
If the loans are not separate, then it becomes much harder to target the non-deductible debt for prioritised repayment. To use a simple example: suppose you use a single debt facility to pay for a $100,000 extension on your home (non-deductible debt) and you also borrow $100,000 to buy shares, using the same debt. You have single debt worth $200,000. Half of the debt is private and half is investment. This means that half of every repayment is used to reduce the investment debt – and half is used to reduce the private debt. If you pay off $20,000, for example, then you are effectively left with $90,000 each of private and investment debt.
Now suppose you used two entirely separate loans for these expenses. You will have two loans, each worth $100,000. You can repay the entire $20,000 into the private loan, leaving you with a balance of $80,000 in that loan. The other loan, for which the interest is deductible, remains at $100,000. The interest on this second debt will be higher, meaning that you will have maximised the amount of tax-deductible interest by keeping the loans separated.
The separation needs to be real, though. Essentially, you need to be able to produce the bank statement for the investment loan and show that every dollar drawn on that loan was used to buy investment assets. And the money needs to flow directly from the loan to the purchase of the asset. You can’t draw the money from a new loan and use it to repay an old loan – this is a private, non-deductible purpose.
You can read some more about the ATO’s thoughts on the deductibility of interest here.
Diagram – prioritising the repayment of non-deductible debt.
The other thing to keep in mind is that there is no way to be tricky when it comes to tax. The tax office has seen it all, and they will understand what you are doing even better than you do. So, try to be tricky and you can expect things to go badly. But there is no need to worry if you do things right. Negative gearing is approved government policy. Here is what Prime Minister Malcolm Turnbull said about it in on his own personal website in April 2016:
“The ability to deduct interest and other costs from personal exertion income has been a generally accepted principle in Australia’s tax system for more than a hundred years.”