Every time you receive a letter or notification from your bank about a revised interest rate, you might find yourself wondering whether you should reduce your loan amount or pay it off completely. After all, many investors aim to retire and live off rental income from their properties.
Tax-Deductible Debt
When you take out a loan to finance the purchase of a rental property, the interest on that loan is tax deductible. However, once you pay off the loan, any future loan will only be tax deductible if it is used for a taxable asset. For non-residents for tax purposes, only taxable Australian property income is subject to tax.
Actual Cost of Interest
As a non-resident, you are not entitled to any tax-free threshold and are taxed at progressive rates ranging from 30% to 45% (effective from 1 July 2024). This means that any tax-deductible interest cost offsets your starting tax rate of 30%.
For example, if your net rental income is $30,000 and your tax-deductible interest cost is also $30,000, you will not have any tax payable. However, if you pay off the loan, you lose the interest deduction, and your taxable income becomes $30,000. At a 30% tax rate, your income tax payable would be $9,000.
In effect, paying $30,000 in interest saves you $9,000 in income tax. Therefore, the actual cost of interest is $21,000.
Loan Example at July 2024
- Variable interest rate on loan: 6.34%
- Interest cost: $30,000
- Outstanding loan balance: $473,186
This means your effective interest rate, taking into account the tax deductibility, is approximately 4.44% ($21,000 ÷ $473,186).
Is the Property Your Future Family Home?
If the property isn’t your future family home, paying off the investment loan means you have less available for your main residence. The last thing you want is a debt-free investment property and a mortgage on your family home.
Dream Home Tip: Set Up an Offset Account
It’s usually better to take a loan on your dream home rather than paying cash upfront. Set up an offset account linked to your home loan. If you decide to rent out the property and live elsewhere, you can withdraw from your offset savings without affecting the tax-deductibility of the loan.
For example, if you have a home loan of $800,000 and $700,000 in your offset account, you will only be charged interest on $100,000. If your offset account holds the full $800,000, no interest is payable.
Conclusion
Interest rates fluctuate. Once you pay off the debt on an investment property, any new loan used for personal or private purposes will no longer be tax deductible. Bank lending regulations and policies will also affect your options. Having an unencumbered property does not guarantee a bank loan since Australian banks assess serviceability.
If you need funds urgently, remember the turnaround time to sell a property, from marketing to settlement, will usually take a minimum of one month.
Returning to the example, the net return you need to beat is 4.44% per annum. Since interest rates fluctuate, this translates roughly to 70% of your current loan interest rate.
If you can outperform this return, it makes sense to keep your tax-deductible debt and use your cash to invest in alternative assets, building a diversified portfolio.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief depends on individual circumstances. You are advised to seek independent tax advice from suitably qualified professionals before making any decision as to the tax implications of any investment.