The deductibility of interest: how the rules work and where they fail

Interest deductibility is one of the more frequently misunderstood areas of the tax system, and the consequences of misunderstanding it tend to be discovered after the fact — when the loan is already in place and the structure is difficult or impossible to change. The principle itself is not complicated. Its application to common borrowing arrangements frequently is.

The foundational rule

Interest on borrowed funds is deductible where those funds have been used for business or other income-producing purposes. The security provided for the loan is irrelevant to this determination. What matters is the use to which the borrowed money has been put.

A homeowner who borrows against an existing rental property to purchase a private residence cannot deduct the interest on that borrowing. The security is income-producing; the use is not. The tax system follows the money, not the mortgage.

Redraw facilities and offset accounts: a critical distinction

These two arrangements are frequently treated as economically equivalent by borrowers. Under the tax system, they are not, and the difference has material consequences.

A redraw facility allows a borrower to access amounts previously repaid against a loan balance. When funds are redrawn, this constitutes a new borrowing. The deductibility of interest on the redrawn amount is then determined by what those funds are used for — the same foundational rule applies.

An offset account operates differently. Funds held in an offset account are treated as the account holder's own money, not as loan repayments. A withdrawal from an offset account is not a borrowing — it is a use of personal savings. The interest consequence of that withdrawal flows back to the original loan, and the deductibility of that interest is determined by what the original loan was used for, not by what the offset funds are subsequently applied to.

The practical difference is significant. A borrower who used a redraw facility to fund an income-producing investment can generally claim the interest on the redrawn amount. A borrower who withdrew the same amount from an offset account linked to a home loan, and applied it to the same investment, cannot — because the underlying loan was used to acquire a private residence.

The offset account contamination problem

A pattern we have seen with increasing frequency involves clients who establish a loan facility with the intention of deploying the funds into investments, then park the borrowed funds in an offset account while waiting for the right opportunity. This creates two distinct problems.

The first is that interest accruing on the new loan while the funds sit in the offset account is unlikely to be deductible. The borrowed funds are not being used to produce income — they are being used to reduce interest on another loan.

The second is more persistent. Parking borrowed funds in an offset account, particularly one that already holds other funds or receives subsequent deposits, can taint the deductibility of interest on the new loan even after the funds are withdrawn and deployed into income-producing assets. Once the traceability of the borrowed funds is broken — because they have been commingled with other amounts in the offset account — the ATO's position is that the nexus between the borrowing and the income-producing use cannot be established.

The damage done by this arrangement is not always recoverable. Restructuring a tainted loan after the fact is complex, and the tax deduction lost in the interim is gone permanently.

In practice

Loan structuring decisions made before funds are drawn are almost always simpler and less costly than remediation after the fact. The question of whether interest will be deductible, and the conditions required to preserve that deductibility, should be addressed before a loan facility is established — not when the tax return is being prepared.

If you are considering a new borrowing arrangement and want to confirm the tax treatment before you proceed, we are available to work through it with you.

Corinne Kirk | EGU Accounting and Taxation
Partner and Senior Accountant

1300 102 542 | 0405 106 401
corinne@egu.au | www.egu.au
GPO Box 1598 Brisbane QLD 4001

This is general advice and has been prepared without considering your objectives, financial situation, or needs. You should therefore consider the appropriateness of the advice, in light of your own objectives, financial situation, or needs, before following this advice. If the advice relates to the acquisition, or possible acquisition of a particular financial product, you should obtain a copy of, and consider, the Product Disclosure Statement (PDS) for that product before making any decision.