We’re on track to increase our wealth by $100,000 dollars over the next 20 years by strategically changing the use of our home loan.
Not by taking on more debt.
Not by changing our asset allocation.
Not by increasing our risk tolerance.
2 transactions were all it took for us to start deducting interest repayments on part of our home loan.
This is a strategy known as ‘Debt Recycling’ (DR).
This article has been on my mind for a while but I really wanted to go through the process firsthand before writing about it. There are a few different ways to do DR but I’ll just be covering how we did it because I don’t know all the nuances with the other methods.
So let’s break it down!
What Defines Debt Recycling
DR = Turning non-deductible debt into deductible debt.
In our case, we wanted to be able to claim our PPoR (Principal Place of Residence) home loan interest as a tax deduction.
Without DR you can’t claim interest from your PPoR loan like you would with an investment property (IP) loan.
How We Did It
*Please note that all the examples in this article will be simplified. Things like rate changes throughout the year, loan repayments and when we officially started DR will remain constant to make it easier to explain.
For simplicity purposes, I’m going to explain our method of DR without our Family trust. I’ll add in the family trust later so everyone who does have a trust can see how we did it but I want to make it simple to start with.
IMO, DR works best when you have a lump sum that you’re planning to invest anyway. That was the position we found ourselves in after we sold IP2 and had over $200K in cash.
We also bought our PPoR last year and I was planning to DR part of our home loan so I made sure that we split it into two parts.
Here is how our situation looked before DR.
As you can see in the above picture, Mrs Firebug (Ladybug in the picture 😂) and I have to pay ~$10K of interest a year for both our home loans (which are secured against our PPoR). These are real numbers (sorry Melbourne and Sydney folk 🙈) when we first settled on our home.
We can’t claim that ~$10K as a deduction because the use of the borrowed funds were for our PPoR and not an income-producing asset.
We also have a lump sum of $211,000 from the sale of our investment property that we would like to invest.
For illustrative purposes, below is how it would have looked if we skipped DR and just invested our cash in shares.
There’s nothing wrong with the above picture but the Firebug Family doesn’t save any tax on their PPoR home loans.
The point of DR is to change the use of the borrowed money for deductions.
We were able to change the use of loan 2 by completely paying it down and then redrawing it out to invest in shares.
This is how it looked after DR Loan2.
¹ Loan2 was paid down and redrawn to purchase shares. Loan2’s interest payments are now tax-deductible
² The Firebug family received $6,330 in dividends but can deduct $6,077 in expenses from Loan2 and thus only need to declare $253 in additional income.
As you can see in picture 2 we were able to change the use of Loan2 to become an investment loan.
We then used this new loan to buy income-producing assets (shares) and are now able to claim a deduction on the accrued interest saving a total of $1,975 on tax.
But how exactly did we repurpose the loan?
In one word… redraw.
Once we sold IP2 and had the large lump sum, I simply paid down Loan2 completely and then redrew it back out.
The above picture shows the balance for Loan2 to originally be $209,508.90 on the 9th of November 2021. I paid it down to $0 on the 29th and then used the redraw facility to pull the $209,508.90 back out straight away. Redrawing from a loan is considered new borrowings by the ATO.
I was very worried that the loan would automatically close so I went down to an actual branch to ensure that it didn’t. The girl that helped me actually knew what DR was which helped a lot.
And that’s basically it.
We essentially are in the exact same position we would have been without DR but now Loan2’s debt is tax-deductible.
How We Did It (With The Trust)
The concept of DR remains the same, it’s just more complicated with a trust. (like a lot of things 😅)
Here’s how we did it.
¹ You need to make sure that the terms of the loan allow for changes in interest rate to be the same as what the bank is charging you. In this example, it’s constant at 2.88% when in reality the interest rate would fluctuate. The loan agreement between the Firebugs and the trustee needs to be in writing and on arm’s length terms too.
² The Firebug Family pay and receive the same amount ($6,077) so their tax position is nill.
³ The distribution is only $253 because the trust had to pay $6,077 in interest to the Firebug Family. The distribution will be taxed at the marginal rate of the beneficiary.
There’s a lot going on in the above picture but I hope it makes sense. Leave me a comment below if you need something explained in more detail.
What If I Don’t Have A Lump Sum?
Not everyone will have a large sum of money to completely pay down a split of their loan. We implement a dollar-cost averaging strategy which means we don’t save up large amounts to drop in at once. The sale of IP2 presented a rare opportunity for us to execute our DR strategy but I understand that won’t be the case for most people.
Annoyingly, I actually had some examples and financial products that are suitable for people who want to do DR whilst DCA’ing. But since ASIC doesn’t let people like me talk about those sorts of things without paying them money, I unfortunately had to delete this part out of the article :(.
Terry W Tips and Future Podcast
I reached out to one of if not the best SMEs (subject matter expert) for DR in Australia for his top tips. I’m also teeing up another podcast with him to do a DR specific episode. Please let me know in the comment section what you want us to cover and I’ll try to add it in 🙂
Terry’s top tips 👇
- You can only claim interest if borrowing to buy income-producing assets
- You need to avoid mixing loans as this will reduce tax savings
- Split loans first before repaying
- Repayment needs to be done once in full
- Redraws can be done in stages
- If borrowing to buy non-dividend paying shares the interest could be a cost base expense so it would still be worth splitting and recording the interest as it will reduce CGT.
- Written loan agreements on arm’s length terms are needed if the borrower and the investor are different
- Never redraw into a savings account with cash as it will cause a mixed loan
- Avoid paying into a share trading account with cash in there as this will cause a mixed loan.
- It is possible to debt recycle with any loan that has redraw, but some loan products are better than others, so see your broker about this.
- Debt recycling is a tax strategy so only registered tax agents or tax lawyers can advise on it.
- Advice on what to invest in would be financial advice if it involves shares or super as these are financial products so only an AFSL holder or authorized representative could advise on this.
- It is possible to debt recycle with investment properties too.
It’s important to note that DR didn’t change our investments, amount of debt, asset allocation or anything else really. We simply changed the use of the borrowed money.
I used the 32.5% tax bracket but this strategy would save you even more money if you have a higher marginal tax rate (I forgot to include the medicare levy too which would have made the tax savings even more impressive).
There’s also a pretty good chance that interest rates are going to rise in the next couple of years.
More interest = more deductions for us.
Oh, and if you’re wondering how I came to that $100,000 number in the intro. I simply punched in $1,975 into a compound interest calculator for 20 years at 8 interest. There are a bunch of assumptions right there but it’s impossible to know how the interest rate will move over that time period and we plan to redraw equity out of Loan1 and Loan2 which will mean more deductions. Essentially, we don’t ever plan to pay off our PPoR loan. I eventually want to DR Loan1 and then continuously redraw equity for the foreseeable future (Thornhill style!).
This strategy is something that took less than a week to sort out but will be saving us money for as long as we have debt against our PPoR.
Pretty cool if you ask me 🙂
Are you doing DR? I’d love to know why or why not in the comments section below.
Spark that 🔥