Owner Occupied vs Investment Loan: Is Owner-Occupied Loan Tax Deductible?

By Ershad Ullah April 21, 2024 | Tags: Property Investment, Finance And Loan, Tax & Accounting, Tax Planning & Tax Tips

Owner Occupied vs Investment Loan: Last week, we explored the nuances of offset accounts versus redraw facilities, sparking an impressive level of engagement from our readers. The overwhelming response highlighted a keen interest in further exposing aspects of property financing. Many of you expressed a desire for a similar deep dive into the distinctions between owner-occupied loans and investment loans. Given the complexities involved, especially regarding tax implications, it’s clear that clarity is needed. This is particularly true when it comes to transforming a primary residence into an investment property—a move that can blur the lines of tax deductibility.

What are the implications of such a conversion? How does the Australian Taxation Office (ATO) view the claim of interest deductions on an owner-occupied loan for a property that is now generating rental income? These questions are not just theoretical but have practical implications that could affect thousands of homeowners. In this article, we will uncover the critical differences, responsibilities, and potential pitfalls in managing these two types of loans, ensuring you make informed decisions about your property and its financing.

Difference between an owner-occupied loan and an Investment Loan:

As the name implies, an “owner-occupied loan” is specifically designed for properties that will serve as your principal place of residence—that is, the home where you will live. On the other hand, an “investment loan” is tailored for properties that you intend to rent out. This distinction is crucial because the financial terms, borrowing capacity, interest rates, and tax implications differ significantly between the two types of loans. You can find many websites covering this topic; however, most only address the banks’ requirements. We have aimed to explore this topic from a broader perspective, examining how banks differentiate between these loans and the impact on individuals in terms of cash flow, serviceability, and tax deductibility.

Interest Rates – Investment loans usually have higher interest rates and fees than loans for homes you live in. This is because lenders see investment loans as riskier. Investors use the money they make from renting out properties to pay back these loans. However, this income can be unpredictable—if fewer people rent or if rental rates decrease, it affects their ability to repay the loan. On the other hand, people who get loans for their own homes typically pay back the loan with their regular income, which is usually more stable.

For instance, a review of current rates from major banks such as the Commonwealth Bank of Australia (CBA) and Australia and New Zealand Banking Group (ANZ) illustrates this point. CBA offers a 6.49% interest rate for owner-occupied home loans, whereas their rate for investment loans is slightly higher at 6.6%. Similarly, ANZ charges a 7.24% interest rate for home loans used by owner-occupiers, but the rate increases to 7.84% for properties intended as investments.

These differences are not arbitrary; they are rooted in the higher risk associated with lending for investment purposes. Since investment properties rely on rental income, which can vary due to market conditions or property vacancies, lenders mitigate this risk by charging higher interest rates. This ensures they have a buffer against potential fluctuations in repayment capacity.

The Loan to Value Ratio ((LVR) – When applying for any property loan, whether it’s for an owner-occupied home or an investment property, lenders will assess your financial situation—including your income, savings, and expenses—to determine how much you can afford to borrow. However, the Loan to Value Ratio (LVR) they require will vary depending on the type of loan you are seeking. The Loan to Value Ratio (LVR) is a key financial metric used by lenders to assess the risk of a loan.

It measures the amount of the loan compared to the value of the property it is used to purchase, expressed as a percentage. For instance, if a property is worth $1,000,000 and the loan is $800,000, the LVR is 80%. Lenders often require a lower LVR for loans on investment properties, meaning you need to put down a larger deposit compared to purchasing a residential property for your own use. This requirement is due to the perceived higher risk associated with investment properties. A lower LVR means you own more of the property outright, which provides more security for the lender in case of loan default, especially in a fluctuating rental market.

Borrowing Capacity – Borrowing power refers to the amount of money a bank determines you can responsibly borrow based on your current financial situation, primarily your income. This calculation takes into account your salary, any additional income you may have, and your existing debts and expenses. The purpose is to ensure that you can comfortably manage your loan repayments without financial strain. When applying for an investment loan, lenders typically factor in a portion of your potential rental income to calculate your borrowing capacity.

This means that you may have a larger borrowing capacity if you take out an investment loan to purchase a rental property compared to an owner-occupied loan for a home you plan to live in. However, it’s important to note that not all lenders follow this practice. By assessing these factors, lenders can provide you with a loan amount that fits within your budget while minimizing the risk of default.

Tax Deductibility of the Owner Occupied and Investment Loan:

One of the frequent questions we receive from clients is whether interest can be claimed as a tax deduction if they rent out their primary residence while the loan remains classified as an owner-occupied loan. The answer to this question hinges on how the borrowed fund is used. If you’ve used the loan to purchase a property that generates rental income, then the interest you pay on this loan is deductible as an expense. The original purpose of the loan (e.g., owner-occupied) is less important than what you actually do with the money.

If the funds are used to produce assessable income, such as by renting out the property, then the interest is indeed deductible. However, if any portion of the loan is used for personal purposes, you will need to apportion the amount of interest you claim accordingly. Remember, you can only claim these deductions if the property is being rented out or is genuinely available for rent.

For example – John purchased his home for $1 million with an owner-occupied loan of $800,000. After living there for two years, he had to move overseas unexpectedly. Due to his sudden move, he couldn’t inform his bank or change the terms of his loan from an owner-occupied to an investment loan, a change that requires his presence in Australia.

While overseas, John decides to rent out his home. Despite the loan still being classified as an owner-occupied loan, he wonders if he can claim the interest against his rental income. The answer is yes. The key factor here is the use of the property. Since the property is now generating rental income, and the interest expense is directly related to earning that income, John is allowed to claim the interest as a deduction on his tax return. This is permissible even though the loan was not officially converted to an investment loan, because what matters for tax purposes is how the loan funds are being utilised—to produce income.

In conclusion, the distinction between owner-occupied and investment loans is critical for homeowners and investors alike, particularly when it comes to tax implications and financial planning. Understanding these differences is essential for making informed decisions that align with your financial goals and responsibilities, especially when considering the potential for turning your home into an income-generating investment property. As we’ve explored in this article, the specific use of the property and how loan funds are utilized are key factors in determining the eligibility for interest deductions. Whether you’re adjusting to changes like converting a primary residence into a rental property or assessing the potential financial impact of such changes, it’s essential to understand these nuances to navigate the complexities effectively.

If you are considering purchasing an investment property or a home and are unsure about securing a loan that will safeguard your tax deductibility in the future, or if you have doubts about the tax deductibility of your current loan interest, do not hesitate to contact us at Investax Group. Our tax specialists are equipped to provide you with the guidance and expertise needed to make informed decisions tailored to your financial goals. Reach out today to ensure your investments are as profitable and compliant as possible.