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Offset vs Redraw: Avoid Tax Deduction Mistakes.

Offset vs Redraw & Tax Deduction Mistakes: I’m in the process of buying a new home and plan to use funds from my existing offset account to cover the deposit, stamp duty, and legal fees. Can I claim the interest on this withdrawal as a tax deduction? Should I use the offset account or the redraw facility to pay for next property? These are the most common questions we get when investors use their first home to purchase the second property for investment purpose. 

 Almost all of us homeowners come across redraw facilities and offset accounts when we take out a home loan to purchase our property. The majority of homeowners know that the purpose of these two home loan features is to reduce interest charges on our loan balances. In this article, we will explore these two home loan features from a tax perspective to ensure you utilise them wisely. The aim is to ensure you’re leveraging these features as effectively as possible, so you don’t accidentally mess up your chances to deduct interest.

Redraw Facility

When you make an extra repayment in addition to your regular loan repayment amount, the additional payment appears in your loan account as extra funds in the redraw facility. A redraw facility allows you to withdraw these funds if needed.

The money in the redraw facility reduces your home loan balance, which in turn lowers your interest payments. When the interest payment is lower, your repayment of the home loan will also be quicker.

Let’s take this as an example where John secures a $500,000 loan with a 25-year term at a 6% annual interest rate. His monthly payments are calculated based on this rate, divided into principal and interest components. In the first year, John’s payments primarily cover the interest due to the loan’s structure, with a smaller portion reducing the principal. The estimated monthly interest will be $2,500.

A year later, John receives a generous $200,000 bonus, which he wisely decides to put into his home loan, directly reducing the principal amount from $500K to $300K. Post-bonus, the interest charged on John’s loan each month sees a significant drop, given the reduced principal. For instance, the interest portion right after the bonus payment falls to $1,500 per month, compared to the higher amounts seen in the previous year. This will allow John to drastically reduce his home loan with the regular monthly repayments.

The $200,000 that John has used to reduce his loan principal doesn’t just vanish; instead, it sits in his redraw facility, waiting like a financial safety net. This means that while it’s currently working to lessen his interest charges, it’s also available for John to draw upon in the future should he need it, offering both immediate benefits and financial flexibility down the line.

Important Facts

  • Redraw Facility is not a separate Account. It is a feature attached to your home loan. 
  • Having funds in your redraw account indicates that you’ve made additional payments to reduce your home loan.
  • You can only redraw on a variable rate home loan, not from a fixed-rate loan.
Offset vs Redraw
The money in the redraw facility reduces your home loan balance

Offset Account

An offset account generally gets issued with a home loan. It is a separate transaction account, and you can use it just like any everyday transaction account. You have the ability to deposit and withdraw into the offset account whenever you like.

The cool part about the offset account is, the money in your offset account helps reduce the amount of your loan that interest is calculated on. The funds in your account work to ‘offset’ your home loan’s balance, allowing you to only pay interest on the difference between your home loan amount and your offset account’s balance.

Taking John’s example from above, after receiving the $200,000 bonus, John reduced his home loan to $300,000 from $500,000. If he changes his strategy and decides to keep the $200,000 in his offset account, John’s loan balance would remain at $500,000. However, John would only pay interest on $300,000, since he has $200,000 in his offset account.

Important Facts

  • It is a separate Transaction account. 
  • Money in offset account doesn’t indicate you have paid the loan down. 
  • In other words, it keeps the original loan as it is. 

Offset vs Redraw – which one is better? 

Even though redraw and offset accounts essentially achieve the same goal of reducing interest on a loan, they differ significantly in terms of tax treatment. 

In this section, we will not cover the difference between the two products and how they benefit individuals from banking point of view. Instead, we will focus on how these two accounts can be used wisely to maximize tax deductions. Let’s use John’s examples to show difference in tax treatment.  

Money in your offset account helps reduce the amount of your loan that interest is calculated on

Purchase a New Home and Rent Out Existing Property

John and his wife are expecting twins in the next six months. Realising that their current apartment won’t be enough to raise the kids, they’ve decided to upgrade their current home.  John used his bonus to reduce his home loan by $200,000, and the $200,000 is sitting in his redraw account. He needs this fund to purchase his new home. John discussed this with his mortgage broker and discovered that his property has increased in value, allowing him to access an additional $100,000 in equity. In total, he can take out $200K from his redraw facility and another $100K from the increased valuation to purchase his new home.

John plans to rent out his current premises when he acquires the new home. He is under the impression that since this property is going to be rented out, he will be able to claim his original loan amount of $500K and the additional $100K, as the loan is related to his investment property.

Unfortunately, this is not correct. Since John paid down the loan by $200K, the withdrawal of the $200K to purchase a new home is not tax deductible. This is because it will be treated as if John is taking out a new loan of $200K to purchase his new home, which is a private property. The purpose of the withdrawal is personal in nature; hence the interest is not tax deductible for the $200K. Similarly, the $100K is also not tax deductible, even though the loan belongs to the existing property, which is the investment property. This is because the $100K loan taken out from this property will be used to purchase his new home.

His total tax-deductible loan for his existing apartment, which will become an investment property, will be $300,000, not $600,000.

Could he have done something differently if he had planned from the beginning that this property would require an upgrade and become their investment property in the future? The answer is yes. If he had placed the money in the offset account instead of reducing the mortgage and kept the money in the redraw facility, the withdrawal of the money from the offset account would have preserved the interest deductibility for the original loan amount of $500K.

Source – ATO 

Purchase a New Investment property and Keep the Current Home as Primary Residence

Now, imagine John and his wife couldn’t upgrade the property due to money constraints, so they have decided to stay in the current property, as it is quite spacious and has a large courtyard. They have decided to rent out their new place. The total withdrawals of $200K from the redraw facility and the new equity loan of $100K from the existing property will be tax-deductible because they are using these funds to purchase a new investment property.

According to the ATO guideline, “If you take out a loan to purchase a rental property, you can claim the interest charged on that loan, or a portion of the interest, as a deduction. However, the property must be rented, or genuinely available for rental, in the income year for which you claim a deduction.”

The journey through property investment demands a deep dive into the nuances of offset and redraw facilities, especially from a tax perspective. While this article aims to shed light on these complexities, it’s crucial to remember that each financial situation is unique, and the general advice provided here may not suit every individual circumstance.

Before making decisions that could impact your property’s loan deductibility and, ultimately, your financial future, it’s wise to consult with your accountant. While there are costs associated with these professional services, they are minimal compared to the potential financial consequences of misinterpreting tax laws. Being correct from the start can protect you against the risk of losing significant amounts in loan deductibility.

If you don’t already have an accountant specialising in property tax, please feel free to reach out to us at Investax Group. Our property tax specialists can review your borrowing structure from a tax perspective and provide you with an overview of the potential tax deductions on your loans.

Pro tips

  1. Understand Your Goals: Before deciding between an offset and a redraw facility, clearly define your financial and property investment goals. The right choice varies depending on whether you aim for quicker loan repayment, tax efficiency, or investment leverage.
  2. Offset for Flexibility: Consider using an offset account if you anticipate needing access to your extra funds without affecting the tax deductibility of your home loan interest, especially if you’re planning to convert your current home into an investment property.
  3. Redraw for Repayment: If your primary goal is to reduce your home loan balance and you’re not concerned about the potential tax implications for investment properties, a redraw facility can be a more suitable option.
  4. Keep Tax Implications in Mind: When using funds from your home loan for investment purposes, always consider the tax implications. The way you withdraw funds can significantly impact your tax deductions.
  5. Consult Before Acting: Always consult with a tax professional or financial advisor before making significant decisions regarding your home loan, especially when considering using your property as an investment.
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