Debt recycling continues to gain popularity within the personal finance space, but so too do the risks of getting it wrong. While the strategy is relatively straightforward to implement, small mistakes can completely undo all of the potential benefits.
This article outlines some of the common mistakes people make when setting up or managing a debt recycling strategy, along with the consequences that can follow.
If you’re new to the concept, we’ve already published a beginner’s guide to debt recycling that covers the fundamentals.
Paying Off the Split in Full
You’ve split your loan into a $100,000 portion to use for debt recycling. You transfer $100,000 in cash to pay off the loan, ready to redraw and invest. A week later, you log in to your banking app to transfer the funds to your brokerage, only to find the loan account has disappeared. What happened?
In this scenario, you’ve unintentionally paid off the loan in full. Because the amount transferred into the loan matched the outstanding balance exactly, some banks may interpret this as a complete repayment and automatically close the loan facility.
This can become a serious problem, as you’ve now lost access to the funds you were intending to invest. While you can contact the bank to request that the transaction be reversed, there’s no guarantee they will agree. Technically, they’re within their rights to apply the funds against the debt and close the facility.
The simplest way to avoid this is to avoid paying the loan down to zero before redrawing. Even leaving just $1 outstanding can be enough, although some banks may still close the account. To be safe, either leave a slightly higher amount unpaid or contact your bank ahead of time to confirm how they handle full repayments. Some banks will keep the loan open even when it’s paid off in full, but this varies by lender.
Not Splitting the Loan for Each Investment
The biggest downside to debt recycling is that it makes dollar cost averaging (DCA) with regular contributions much more difficult. Each time new cash becomes available to invest, the loan must be split again to maintain full deductibility.
This can be time-consuming, and many lenders have relatively high minimum split amounts, which makes monthly investing unrealistic. Someone with $2,000 per month to invest would not be able to actually invest on a monthly basis.
In this case, someone wanting to debt recycle their monthly savings would need to accumulate funds over the course of the year and then make a $24,000 loan split before investing. The downside of this approach is being out of the market for that entire year.
There’s a temptation to avoid the hassle by using one large split, or not splitting at all, and simply paying funds into and out of the same redraw facility whenever new investments are made. Since money drawn from the loan is still being used for investment purposes, it may appear to preserve deductibility.
This will work as intended precisely once. After that, the loan becomes mixed, and deductibility is progressively eroded.
Mixed Loans & DCA
A mixed loan arises when a single loan is used for both personal and investment purposes. Only the portion used for investment is tax deductible.
Using a large loan split and not fully repaying it between investments creates a mixed loan. For example, a $1 million loan with $100,000 drawn for investment purposes would be 90 percent non-deductible and 10 percent deductible.
This might not seem like an immediate problem, until further repayments are made. If the investor adds another $2,000 to the loan in order to redraw and invest again, the deposit also repays a portion of the already deductible loan. In our example, each $2,000 deposit repays $200 (10 percent) of the deductible portion.
The core of debt recycling is to pay down non-deductible debt, redraw, and convert it into investment debt that is deductible. But in this case, the process partially repays the deductible portion each time, undoing some of the strategy’s benefit. If the loan is also on a principal and interest basis (P&I), the regular repayments will also erode the deductible balance proportionally.
Whilst this does not make tax deductions ineligible, it is a nightmare to track. Any benefits of having more money in the market sooner could easily be eaten up by extra accounting fees.
It also reduces the total amount of deductible debt that can be achieved. The chart below compares two approaches over a five-year period. Both invest a total of $220,000 ($100k upfront, $2k per month) via debt recycling. One invests monthly through the same loan split, while the other saves and invests $24,000 annually through a new split each time.
Even though the total investment is the same, the mixed loan approach ends up with less deductible debt at the end of the five years. If repayments were being made on a principal and interest basis, the gap would be even wider.
On balance, incorporating a DCA strategy into debt recycling is highly unadvisable. It nearly always leads to a mixed loan, which is a nightmare to manage and results in a lower overall tax benefit compared to waiting until you can create a new loan split.
There is a potential workaround using an equity-out loan from the property, which we’ll cover in a future article.
Not Buying Income-Producing Assets
For the interest incurred through a debt recycling strategy to be tax deductible, the investment must have a reasonable expectation of generating assessable income in a given financial year. This means you cannot debt recycle into assets that do not produce income and then claim a deduction for the interest.
Examples of such non-income-producing investments include:
- Cryptocurrency
- Some listed investment companies
- Direct shares with little expectation or history of paying dividends
- Property that is not leased
In these cases, annual tax deductions cannot be claimed. However, the interest expense can be added to the cost base of the asset, which reduces the capital gain and the amount of CGT payable when the asset is eventually sold.
This can offer a partial benefit, but it is generally less favourable than receiving a tax deduction each year. The reduction in CGT is also halved due to the 50 percent CGT discount that applies when the asset is held for more than 12 months.
Lack of Direct Link from Debt to Investments
A key requirement of a debt recycling strategy is being able to demonstrate that the borrowed funds were used solely for investment purposes. In practice, this means the funds should take the most direct route possible from the loan redraw into the investment.
This can be tricky in some cases, as certain banks do not allow direct transfers from a loan account to an external account, such as a share brokerage. Instead, the funds must first go into a regular bank account before being sent to the brokerage.
On its own, this is usually not a problem. Moving money from the redraw, to a bank account, and then on to the brokerage is generally acceptable. The issue arises when other money is already in the bank account and is mixed with the borrowed funds used for the transfer.
If borrowed funds are deposited into an account that already holds other money, there is precedent to suggest the ATO may deny part or all of the interest deduction. This is due to a perceived breakdown in the connection between the borrowed funds and their use for investment.
The same principle applies to cash accounts within brokerage platforms. Best practice is to ensure that any account receiving borrowed funds has a zero balance beforehand, and that the money spends as little time in the account as possible before being invested.
Selling Investments Without Tracking Parcels
This becomes a concern when looking to unwind part of a debt recycling strategy. If there are multiple loan splits in place and the intention is to sell only enough assets to pay down one of them, accurately tracking the share parcels becomes essential.
As with the initial investment, maintaining a clear link between the borrowed funds and their purpose is equally important when repaying the loan. When selling investments to reduce a loan split, the shares being sold must be the same parcels originally purchased using that specific borrowed amount.
If different parcels are sold, often done to reduce capital gains tax, it may create a mismatch and limit the deductibility of the remaining loan. Selling shares associated with one loan split and using the proceeds to pay off another disrupts the connection between the debt and the investment, which could lead to some or all of the interest no longer being deductible.
Because of this, tracking which parcels of shares are tied to each loan split is critical when using a debt recycling strategy.
Summary
Debt recycling is a relatively straightforward strategy, but it relies on each step being executed precisely. Small missteps, such as repaying a split in full, failing to track loan splits or share parcels, or creating mixed-purpose loans can reduce or even eliminate the tax benefits the strategy is designed to achieve.
If you are not confident with every part of the process, seeking professional financial and tax advice is advisable. Be aware that not all accountants or financial advisers are familiar with the finer details of debt recycling. It is important to engage someone with practical experience in both advising on and implementing the strategy correctly.
