You’ve got surplus cash and a big mortgage. You are trying to decide whether to put the excess cash into super or pay off the mortgage. If you decide on paying off the mortgage there’s another thing to consider.
While you’re living in your home, paying off your mortgage is reducing a debt on which the interest is not tax deductible. This makes good sense. But what if you later decide to borrow some money to buy a new home and keep the existing one as an investment property? Unfortunately, interest on the loan for the new home is not tax deductible. At the same time, you’ve reduced or eliminated a debt on which interest would have become deductible once your old home was rented out.
Let’s say you owe $700,000 on your home mortgage and come into some money and you now have $1M in cash available. You decide to pay off the mortgage. A year later you decide the time is right to upgrade, and find a new home for $1.8M. You love your old home, and want to keep it as an investment. As you paid off the mortgage and now only have $300,000 left of cash, you have to borrow $1.5M to make the purchase. Unfortunately, because the new loan was used to buy your new home which you will live in, interest on it will not be tax deductible.
The solution is, instead of paying off your mortgage, deposit surplus cash into an interest offset account attached to the original loan. In this way, should you decide to move out of your home and rent it out, you simply withdraw the cash from the offset account and use it to fund your new home purchase. The original loan is still in existence and the interest that you will then start being charged again will be tax deductible.
In the above example, you could have placed the $700,000 of your cash in an interest offset account. This would mean you would not be incurring any interest on the mortgage, but the loan itself would still be in place. When you purchased your new home, you would withdraw the $700,000 from your offset account and use it for the purchase of your new home. The interest on the $700,000 would then be tax deductible, which depending on interest rates and your marginal tax rates, could save you up to $15,000 per year of tax. You still have the same total loans after buying the new home (ie $1.5M), except now the loans will be $800,000 non deductible and $700,000 deductible, as opposed to be totally non deductible if you didn’t plan ahead.
While this strategy might not always be appropriate, you should always think carefully before you decide to make additional principal repayments on your mortgage. This is especially so if you have plans to use funds for non-deductible purposes at some stage in the future.
In short keep the available cash for non-deductible purposes and try to only keep loans in existence that bear interest that is tax deductible to you. If you have any doubts, call us first, before you restructure any of your borrowings.
*Correct as of December 2015
*Disclaimer – this article has been produced by Kreston Stanley Williamson as a service to its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas contained in this article, it is imperative you seek specific advice relating to your particular circumstances. Liability limited by a scheme approved under professional standards legislation.