Home equity investment loan - hypothetical question

[luap77]

I have a hypothetical question (i.e. I am not seeking personal tax advice) about using a home equity loan for investing and would greatly appreciate your replies to this. I have simplified my numbers and have not considered repayments (which complicate things) in the following explanation and question:

My understanding is that a home equity loan can be used as an investment loan when the money is applied to income producing purposes (shares, saleable assets etc). As such, the loan interest for the portion of the borrowed funds applied to income producing purposes is tax deductible. In other words, if a person took out a $500,000 home equity loan (line of credit) and used $250,000 to purchase a home and the remaining $250,000 for income producing purposes, then half of the loan interest (say rates at 10% for the purposes of this example) would be tax deductible. So, the person could claim $25,000 as a tax deduction - just like the tax deduction for interest on an investment loan of $250,000. Assuming the person has a really big salary (once again, for simplicity) and pays 50% tax on a reasonable whack of it, then this would represent a saving of $12,500. In other words, the $250,000 used for income generating purposes was effectively borrowed at an interest rate of half of the loan interest rate (5%). My understanding is that this is correct. Any comments on this? It is covered in tax ruling TR200/2. Now taking this to another level:

If the $250,000 was drawn and placed in a term deposit (i.e. income producing purpose) earning 12% interest (the key thing is that it is higher than the interest rate on the loan) then this interest earned would be subject to the persons 50% tax rate and thus end up being 6% after tax. As such, the person has made a profit of 1% on the $250,000 ($2500) just for taking a bigger loan than they needed and using half of it for income generating purposes. Obviously this only works if the person can access a term deposit that pays a higher rate of interest then the home equity loan, and managed to secure such a loan in the first place. My questions are: is my understanding correct? Can it be done this way? Wouldn’t this be particularly attractive if this person had a low fixed-rate home equity loan and could access safe income-producing high-rate term deposits?

Perhaps this is too good to be true or I have made an obvious error in my understanding; hence this post. My thanks to those who take the time to reply.

Happy New Year.

 

[Ozymandias]

I believe that's correct, but I've never put it to the test... The tax department shouldn't care where the loan has come from or what the loan product is called, only that you're paying interest on money used to invest.

Related question: if you've gotten ahead on your mortgage payments and decide later to redraw those funds for an investment, can you then claim the extra interest on the redrawn funds against tax? If yes, put all your funds through your mortgage first for an instant tax deduction! However I suspect this not the case - too easy, and too obviously a cheat.

 

[gooner]

Tax is right

Flaw in the scheme is that banks would go out of business if they paid more for their borrowed money (term deposits) than their lent money (home loans)

 

[suhm]

you could also borrow money to put into super, claim the interest against your income and put the money into super, works better if your tax rate in super is 0 and your in the 40+% tax bracket so depending on the rate you get for your cash you could get about 1-3% a year for borrowing the money.

 

[gooner]

you could also borrow money to put into super, claim the interest against your income and put the money into super, works better if your tax rate in super is 0 and your in the 40+% tax bracket so depending on the rate you get for your cash you could get about 1-3% a year for borrowing the money.

Except you can not claim a tax deduction for interest on funds borrowed to put into super. Apart from that, nice idea

 

[luap77]

Thanks for the replies so far.

Ozymandias; my understanding is that any funds redrawn for investment purposes are fully deductible for as long as they are applied to investments with the potential to generate income. Calculations can be daily or monthly or other (via proportioning of income:non-income producing application). The key principles along with examples are covered in TR2000/2 as far as I can see. Since interest on home loans usually accrues daily, a given parcel of funds are considered as either in the mortgage or in an investment at any one time. I'm not sure how 'putting funds through the mortgage first applies here.

Gooner; there are lots of people with line of credit home loans (home equity) still at 6% interest or below having been taken out before rates started climbing. Presumably it would be possible for somebody in this situation to redraw money up to the credit limit (if they had managed to get ahead in the loan or had a credit limit higher then they originally needed for their home) and put this in one of the several high-interest term deposits currently offering more than this rate of interest. Does this sound plausible? Again I may be way off here, but I can only think that it might be possible because the banks don't have that many of their customers in such a loan or the ability to redraw any more money due to already being at their limit.

Suhm; thanks for the tip. That's a good one.

Since this approach may be workable (with success depending on the return investment, of course), has anybody actually tried something like this?

 

[prawn_86]

Luap,

Not the exact same situation as what you are proposing, but my old man has a very small mortage for tax purposes, so recently he has put the same amount of free cash into a term deposit, which is paying more than his mortage rate, so the returns from the td cover the interest payments on the mortage.

 

[DocK]

Thanks for the replies so far.

Ozymandias; my understanding is that any funds redrawn for investment purposes are fully deductible for as long as they are applied to investments with the potential to generate income. Calculations can be daily or monthly or other (via proportioning of income:non-income producing application). The key principles along with examples are covered in TR2000/2 as far as I can see. Since interest on home loans usually accrues daily, a given parcel of funds are considered as either in the mortgage or in an investment at any one time. I'm not sure how 'putting funds through the mortgage first applies here.

Gooner; there are lots of people with line of credit home loans (home equity) still at 6% interest or below having been taken out before rates started climbing. Presumably it would be possible for somebody in this situation to redraw money up to the credit limit (if they had managed to get ahead in the loan or had a credit limit higher then they originally needed for their home) and put this in one of the several high-interest term deposits currently offering more than this rate of interest. Does this sound plausible? Again I may be way off here, but I can only think that it might be possible because the banks don't have that many of their customers in such a loan or the ability to redraw any more money due to already being at their limit.

Suhm; thanks for the tip. That's a good one.

Since this approach may be workable (with success depending on the return investment, of course), has anybody actually tried something like this?

I've never had a fixed interest loan that allowed for re-draws. My understanding was that most line of credit type facilities were at variable rates. Any home equity loans still fixed at 6% would be unlikely to allow a redraw at the original fixed rate imo. Would be very interested to know where such a loan could be obtained if I am incorrect (as I very well may be).

 

[UMike]

I've paid my house off a while ago and organised a redraw solely for investing purposes. Therefore it is tax deductible.

Hope that helps.

 

[Ozymandias]

Related question: if you've gotten ahead on your mortgage payments and decide later to redraw those funds for an investment, can you then claim the extra interest on the redrawn funds against tax? If yes, put all your funds through your mortgage first for an instant tax deduction! However I suspect this not the case - too easy, and too obviously a cheat.

To answer my own question, having read some of TR2000/2, yes, you can do this!

Example: Say I get paid $10k per month, and have a mortgage at 10% (pretend it's the end of the Howard years). After living expenses and the minimum repayment on my mortgage I am left with $5k. I could 'dunk' this $5k into my mortgage, by depositing and then immediately redrawing it. Invest it into my favourite income producing stock and this magical and (for all intents and purposes) gold plated $5k, will then give me a tax deduction of $500 p.a.!

Except it's not quite that simple:

Paragraph 21. of TR2000/2, when repaying the principal of the loan, "the taxpayer cannot choose to notionally allocate the repayments to a particular portion of the total debt". The examples spell out that it must be split proportionately.

So if my loan is $200k total, and my next payment is $2k off the principal, then 2.5% of that $2k must come off the $5k. Or $50. So my income producing loan is then reduced to $4950.

If any of this wrong then please correct me before I destroy my finances!

 

[MITCH027]

Not sure where that 2.5% came from, however only the interest is tax deductible

E.g. if you borrow 200k, your interest payments of approx $20k per year are tax deductible (assuming you are on an interest only loan)

When people borrow to generate revenue, generally they do this usually utilising interest only loans as repaying principle is never tax deductible

From my limited understanding of tax, the tax deduction is there to work against any income you generate. If you pay $1 in interest to make $2, you still pay tax on that $1 profit (at 30%).

This is generally calculated at the end of the FY in your tax return, but you can get your accountant to vary your withholding tax from your employer (similar to what they do with car allowances). This way, you don't have to wait until the end of the year to claim the benefit

 

[suhm]

Except you can not claim a tax deduction for interest on funds borrowed to put into super. Apart from that, nice idea

I stand corrected, tax is such a complicated minefield, (the difference in tax deductibility of taking money out a mortgage offset account and a redraw account ranks up there for me as well), I previously thought if you borrowed the money and used it for investment purposes it was tax deductible.

I'm confused at how financial planners could have spruiked borrowing a million to contribute to super when its not tax deductible.

I'll have to ask the accountant about borrowing money to put into my first home owner acount since its a super like structure I'm a young one so super isn't really in my planning at present, far to long before i am able to withdraw from it.

I guess the only way to do it would be to capitalise the interest on an investment loan and put your dividend money into super.

 

[TheRage]

I'm confused at how financial planners could have spruiked borrowing a million to contribute to super when its not tax deductible.

I am still yet to meet a planner who spruiked borrowing a million to put into super. I know many who have invested the 1 million from another source to take advantage of the contribution caps leaneancy for the purpose of the difference in tax rates being that Super is taxed at 15% on earnings and 10% CGT. Or Pension being taxed at 0% and 0%. Regardless of where it was invested within Super (shares, Property, Term Deposits etc) the person investing if near retirement was clearly better having within the Super structure/ Pension.

By the way tax deductibility is nice but it should not drive the investment decision. Timbercorp, Westpoint Etal offered tax deductibility but look at the outcome. These were spruiked as you termed it by Accountants and Advisers alike.

 

[Krusty the Klown]

I'm confused at how financial planners could have spruiked borrowing a million to contribute to super when its not tax deductible.

What you are talking about was a window of opportunity that closed when contributions were capped a few years ago. It was a strategy to beat the contribution cap introduction deadline.

In a small amount of cases it was beneficial to do this. You had to be over 50, and it would only work where you could pay back the loan very quickly over a short period of time, say if you were expecting a large sum in the near future.

The benefit was getting $1M in to a low tax environment and then being able to take it out tax free in pension phase.

You had to do the calculations beforehand, of course, to make sure it was worth it and take on the regulatory risk of rule changes along the way.

It works in theory if you are a high net worth individual. Did anybody actually do it? I don't know.

 

[SmellyTerror]

Here's something I did with my home loan, and got advice from the ATO to make sure it was legit (don't believe me, though! I'm just a random fool on the internet. DYOR):

We sold a property and put the proceeds on our home-loan's redraw facility while we worked out what to do with it. Took most of it back off to buy shares, and then some more to use as a deposit in another poperty.

Because it was back on the house, reducing the total effective loan, and then taken off again for investment purposes, that proportion of our home loan's interest payments are now tax deductible. I'll pay some of that loot back a long way down the track when I sell the house (that proportion of the house will be subject to CGT, though reduced by 50% since I've owned the asset a long time), but hey, it'll be a long time before that happens, and I intend to make that money work pretty hard until then.

Now those guys seem to put a lot of stock on "intent", so I guess you'd need to make sure you weren't doing something complicated to game the system (check with your advisor), but the ATO told me that the money only needed to be on there for a moment to count.