A common problem that I come across with people that have borrowed money to buy an investment property and also have a home loan is the way that they view these debts.
There is a big difference between the interest on tax deductible and non tax deductible debt in that the first (which is generally referred to as investment debt) can be claimed as a tax deduction whilst the second (which is generally referred to as personal debt) can’t be. See Note (1).
What’s important here is that you need to be aware of the true cost of the interest that you have to pay.
To keep it simple, let’s assume two loans for $300,000 at 6%. The annual interest on both is $18,000.
| Loan Amount | Interest Rate Assumed | Annual Interest Amount | Reduction In Taxable Income | Tax on annual income | Tax Savings |
|
| Personal Debt | $300,000 | 6% | $18,000 | NIL | $18,747 | n/a |
| Investment Debt | $300,000 | 6% | $18,000 | $18,000 | $12,627 | $6,120 |
This information has been provided to highlight the benefit of paying down non tax deductible debt first. It’s easy to look at the “cost” of holding an investment property and feel the need to reduce the debt against the property but it may not be the best approach if you have personal debt that can be paid down first.
Some points to note with this are
- the figures do not allow for any rent received which will affect the reduction in taxable income and therefore the tax savings;
- the gross income in both examples is $80,000 but the tax deductible interest being claimed for the investment property effectively reduces this to $62,000 for tax purposes; and
- the taxation rates have been calculated based on the rates that apply at 1 July 2013 and include the medicare levy.
The bottom line is obvious. You should always be paying down any non tax deductible debt (or personal debt) before you pay down any deductible debt because of the tax implications.
Note (1): This is general advice based on our interpretation of the legislation that applies and should be checked with your own tax adviser.
