Debt recycling as a strategy is experiencing a vogue. One cannot spend a day on an Australian finance forum without seeing a question directly related to it.
As with any financial strategy being explained on the internet, misconceptions are rife. This article will attempt to properly explain what debt recycling is, as well as specifically what it isn’t.
What is Debt Recycling?
First and foremost, you must understand that debt recycling is not an investment strategy itself, it is a tax strategy.
It is the process of turning non-tax-deductible debt into tax-deductible debt. In other words, recycling it.
What non-deductible debt do most people have? Their home loan. So, logic dictates that most debt recycling strategies are done using debt against your personal home.
Debt recycling requires you to have some level of free cash, as well as a non-deductible loan that you wish to begin to convert to being deductible.
What makes a debt deductible?
To understand debt recycling, you must understand why your home loan is not tax deductible, and the change that must be made in order to make it so.
In simple terms, interest payments on a loan may be tax deductible if the funds borrowed are used in a way that produces assessable income.
And so, because your home does not produce income, the interest is not tax deductible.
An example of a loan that is used to produce income is for an investment property. The rent is the income, and thus the interest payments are now an eligible tax deduction.
So, how do you do the same thing with your home loan?
How does debt recycling work?
Well, firstly you must have some level of cash that you wish to invest. The reason for this is that in order to create loan deductibility, as we previously ascertained, you need to create a form of assessable income. Therefore, an investment must be made.
The most common form of investment most people make is into shares and ETFs. This is because they are easily accessible and do not require a large upfront investment. However, it does not necessarily need to be these options, the ATO does not place restrictions on this. It just needs to be reasonably expected to create income.
You could debt recycle into an investment property or even a high-interest savings account, although the outcome may not be positive only using a bank account.
So, you have your cash and you’ve chosen an investment. When does the recycling part start? You can’t just invest this money and start to claim a portion of your home loan, the ATO wouldn’t be too happy with this.
The mechanics of debt recycling
As previously ascertained, the ATO determines deductibility of a loan by looking at the purpose of those funds. Right now, the entirety of your home loan has been used for the purchase of your home, thus it is not deductible. How do we change this?
We need to create a new loan utilising your existing home loan, for which we can then use these funds for investment purposes. We do this by physically paying the funds that you intend to use for investment, off your existing loan. That is, making an extra repayment on your home loan.
By paying extra money off your existing home loan, this should create a redraw facility equal to your extra deposit. However, to be 100% sure you should always check with your bank that this will happen for your situation. A redraw facility allows you to access the extra repayments you have made to your home loan.
What is important to understand is that when you take money from your redraw facility, the ATO will now treat this withdrawal as a brand-new loan when they determine tax deductibility. This is outlined in a specific tax ruling.
This is the crux of what debt recycling is. If you withdraw from a redraw facility and immediately use the funds to generate assessable income, the resulting interest charges will be tax-deductible.
The assets you buy with that money are up to you, but it must be able to be proven to generate or have had the intention of generating assessable income in order to claim a deduction.
The income you generate from your investment can now be used to make extra repayments off your home loan. Which can then subsequently be redrawn again, invested and made deductible. This is why it is called recycling.
Many debt recycling articles on the internet are either wrong, or far too complex. This is a simplified version of how the process actually works.
The diagram below shows the very simple mechanics of how this strategy works:
What isn’t debt recycling?
To be very clear, debt recycling does not mean borrowing to invest. Debt recycling is a tax strategy and does not increase your level of total debt, unless you specifically want it to.
Borrowing to invest may commonly involve getting an additional loan using your home’s equity in order to invest. This new loan will be tax deductible, as its purpose was to purchase income bearing assets.
This is not considered debt recycling. It can only be considered debt recycling once the income generated from these investments is paid against the existing home loan and then redrawn, recycling the existing debt into being deductible.
Debt recycling can be done without increasing your level of total debt. If you used money you had built up in a savings account, you would only be changing the percentage of your loan that is deductible, rather than increasing your level of total debt.
This would be considered a riskier strategy than leaving it in your bank account (assuming you invest in shares, property etc) but it does not increase your level of debt.
General considerations
Without making specific recommendations, there are a few generally accepted practices to follow when undertaking a debt recycling strategy.
Creating loan splits
It is generally a good idea to split your loan each time you wish to debt recycle new funds. By creating separate loan splits, you can more easily track which portion of the loan is for personal use (non-deductible) and which is for investment purposes (deductible).
This makes it simpler to calculate and claim the correct interest deductions on your tax return. Additionally, it helps avoid mixing personal and investment debt, which can complicate tax reporting and potentially lead to issues with the ATO. Always consult with your lender to ensure the loan split process is done correctly.
Needing to split your loan each time will obviously limit how often you can debt recycle, as you’re unlikely to create loan splits for small amounts like $1,000. However, this is a downside that cannot really be overcome.
Interest-only
Many people opt for an interest-only loan split when implementing a debt recycling strategy. With an interest-only loan, your repayments cover only the interest on the loan, which reduces your immediate outgoings and frees up more cash for investment purposes. This can make it easier to manage cash flow while maximising the funds available to invest in income-generating assets.
Keep in mind that interest only loans usually attract a higher interest rate.
Clear Link Between Borrowed Funds and Investments
One key requirement for claiming tax deductibility in a debt recycling strategy is proving a direct link between the borrowed funds and the income-generating investment. The ATO mandates that loan funds must be used exclusively for investment purposes, and maintaining detailed records is crucial.
Try to ensure the shortest journey between your redraw and your investment, as deductions have been denied when funds have been mixed with other assets. Clear documentation of withdrawals and investment purchases is essential to demonstrate that the funds were used solely for income-generating purposes. Failing to provide this proof may result in deductions being disallowed.
Consulting with professionals
Given the complexity of debt recycling, it’s highly advisable to consult with financial and tax professionals before implementing the strategy. While debt recycling can offer significant tax benefits, it also carries risks if not executed properly.
A financial adviser can help tailor the strategy to your individual circumstances, ensuring it aligns with your long-term goals, whilst an accountant can help ensure compliance with ATO regulations and assist with proper record-keeping.
Professional guidance is essential to avoid pitfalls like misreporting or inadvertently creating a mixed-purpose loan, which could result in denied deductions or financial setbacks.
Summary
This article is not intended to persuade you of the benefits of debt recycling, but rather to provide a straightforward explanation for those new to the strategy.
Debt recycling, like any financial strategy, may be highly beneficial for some but unsuitable for others. Its effectiveness depends entirely on your personal financial situation, goals, and risk tolerance. Only you, with the help of a qualified financial professional, can determine whether this strategy aligns with your needs and long-term objectives.
