Property investors can reap significant tax benefits by taking out an interest-only loan with an offset account. Find out how you can apply this strategy.
Interest-only home loans with an offset facility can be attractive for investors as they allow you to reduce your monthly repayments, minimise your non-deductible debt (and increase your deductible debt), and secure a good return (capital gain) if you purchase a principal place of residence (PPR) and then convert your home into an investment property.
While some borrowers may be swayed by the draw cards of a principal and interest loan, taking out an interest-only loan with an offset account is an effective tax strategy if you have the financial discipline to make regular extra repayments into the offset account as it can reduce the amount of interest payable on your mortgage.
For many, opting for an interest-only mortgage with an offset account requires a shift in attitude and gaining sound knowledge about the financial benefits of this structure. It’s also strongly advised that you seek advice from a savvy mortgage broker and a tax accountant to make sure you understand the tax implications involved.
How does an interest-only loan with an offset work?
If you want to minimise your taxable income and lower your monthly repayments, then you may want to set up an interest-only home loan with a linked offset account.
An offset account works in a similar way to a transaction account; however, it reduces the interest payable on your mortgage by the amount held in the account. That is, the account effectively reduces or offsets the amount of interest you pay on your home loan.
For instance, if you had a mortgage of $450,000 and you had $25,000 in your offset account, you would only owe the bank $425,000. When the lender calculates your daily interest, you’d only be charged on the $425,000 owing, instead of the $450,000.
With an interest-only loan, you will only pay the interest portion of the loan and thus your periodic repayments will be lower compared to a principal and interest loan. When you make extra repayments into the linked offset account, this gives you increased flexibility with your finance strategy. Maintaining your savings in an offset account acts as a safety net should your situation change in future, such as if you wanted to purchase an investment property.
What are the benefits of using an offset account on an interest-only loan?
Opening an offset account on an interest-only loan has several benefits for investors, including:
- Lower repayments. As mentioned above, as you will only be paying the interest portion of the loan, your periodic repayments will be lower, freeing up your cash for other investments.
- Tax deduction. You can claim a tax deduction for interest paid on your property if it is clear that the purpose of the loan is for investment. To claim the interest as a tax deduction, you should focus on reducing the interest payable on the non-deductible debt.
- Separation of debt. With an interest-only home loan, you can keep the original debt separate. You can then put savings into an offset account against any debt that’s not tax deductible. This means you can move your savings to whichever debt is not tax deductible, which helps separate your debt.
- Contingency buffer. An interest-only mortgage with an offset facility effectively provides you with a contingency buffer to cover unexpected costs or a lifestyle change.
Turning your home into an investment property
It’s likely that the first home you buy may not be the ultimate principal place of residence (PPR), and thus you may decide to turn your PPR into an investment property.
The Australian Taxation Office (ATO) states that once you pay off your debt, you can’t withdraw on the debt to get a tax deduction unless it’s for investment reasons. If you moved out of a house and decided to convert it into an investment, the tax deductible amount will be lower compared to the original loan amount.
If there’s a possibility that you may turn your existing home into an investment, then having an interest-only home loan and making extra repayments into an offset account can be useful. This is because you are effectively building up a cash buffer which you can use in the future to help purchase another property.
As you may not have fully repaid your existing mortgage, this will allow you to reap the benefits of higher tax deductions on this debt.
Buying a home in the future
It’s likely that you may purchase another home in the future and this debt will be non-deductible as it’s your primary place of residence. If you’re thinking of buying a home in the future, you’ll need cash or equity to cover the deposit (as a bare minimum). If you have this cash sitting in an offset account, you can access it as you need it and also get the tax benefit.
If there’s a chance that you may purchase a residential property in the future, you want to ensure that you have as little interest payable as possible as it will be non-deductible. You should therefore work towards building up your savings in an offset account as you can use this towards buying a home further down the track. This allows you to minimise your non-deductible debt while maintaining the same level of tax-deductible debt.
How can I go about setting up this structure?
Before you take out an interest-only loan with an offset account, you need to work with a savvy mortgage broker, financial planner or tax specialist to evaluate your financial position. Identify the amount that you can afford to put into the offset account each month and discuss your investment strategy with them to see whether this structure will allow you to meet your investment goals.
If you make additional repayments during the interest-only period, and you can cover the extra repayments when the loan reverts back to principal and interest, then an interest-only loan with an offset could be a good structure to consider.
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Compare interest only home loans with offset accounts
Principal and interest vs. interest-only with an offsetAndrew purchased a two-bedroom apartment in Victoria (VIC) and took out a $450,000 mortgage to finance the residential purchase. The loan was set up as principal and interest (P&I) and Andrew worked to pay off his debt as soon as possible.
It’s six years on and Andrew has managed to get his loan down to $250,000. However, Andrew has now decided that he would like to buy a bigger house, and maintain his two-bedroom apartment as an investment property.
As Andrew has $250,000 owing, when the property becomes an investment, he can only claim interest on a $250,000 loan even though the property value has appreciated over time, and is now worth around $600,000.
Andrew wanted to use the equity from his first property to help purchase his next one. However, the equity that he can access from his two-bedroom apartment won’t be tax deductible because it’s being used to purchase a primary place of residence (PPR).
As a result, Andrew has minimised his tax deductible debt and increased his non-deductible debt which is not a good tax outcome.
What’s the solution?
If Andrew had taken out an interest-only mortgage with an offset account, he could have resolved this problem.
Instead of paying down the principal portion of the loan, Andrew could put his additional savings (that would otherwise be principal repayments) into the offset account. This would have helped Andrew minimise the interest payable on the outstanding loan amount.
When he converts his property into an investment, Andrew could withdraw funds from his offset account and use the funds as a deposit for his next property purchase. Instead, Andrew would have increased his deductible debt and minimised his non-deductible debt.
What should I keep in mind when pursuing this strategy?
- Expert advice. Seek independent tax advice before taking out an interest-only loan with an offset facility. Speak to a mortgage broker regarding your investment strategy and the structure of your home loan to ensure that this is the right option for you.
- Regular extra repayments. For this strategy to work, you need to make sure that you’re making regular additional repayments into the offset account. If you don’t have this financial discipline, then this structure may not be right for you.
- Don’t withdraw from offset. If you use an offset account with your interest-only mortgage, make sure you won’t be tempted to withdraw from the account as this can work against your investment strategy.