This tax season has brought a noticeable increase in queries about whether loan interest can be claimed as a tax deduction. It’s a valid question, as the way interest expenses are handled can have a major impact on your overall tax outcome. The challenge is that the rules can be complex.
Purpose of the loan
The key factor in determining the tax treatment of interest is the actual use of the borrowed funds—essentially, why you took out the loan.
Generally, for interest to be deductible, you must be able to show that the borrowed money was used for business or other income-generating purposes. The asset used as security for the loan does not affect this assessment.
For example, if Harry borrows money to buy a private home but uses his rental property as security, the interest will not be deductible because the loan was used to purchase a private asset, despite being secured by an income-producing property.
Redraw vs Offset Accounts
Although these arrangements might appear similar in their economic effect, the tax treatment can be quite different—making this an area where extra caution is needed.
If you have an existing loan, pay down part of the balance, and then use a redraw facility to access those funds again, the transaction is considered a new borrowing. From there, the “golden rule” applies: the tax treatment depends on what the redrawn funds are used for.
An offset account works differently. Money in an offset account is treated like personal savings. Withdrawing from it is not considered borrowing, even if doing so increases the interest charged on a linked loan. In this case, you assess deductibility by looking at the original purpose of the loan.
Here’s a comparison of two scenarios that may look alike economically but are treated differently for tax purposes:
Example 1: Lara’s Redraw Facility
Five years ago, Lara took out a loan to purchase her primary home. Since then, she has made extra repayments towards reducing the loan balance.
Lara withdraws a portion of the funds through her redraw facility and uses them to purchase listed shares. This creates a mixed-purpose loan—one part relating to her main residence, where the interest is not deductible, and another part linked to the investment in shares, where the interest on that portion is generally deductible, as the funds were used to acquire income-producing assets.
Example 2: Peter’s Offset Account
Peter also borrowed to buy his main residence, but instead of making extra loan repayments, he placed additional funds into an offset account, reducing the interest charged on his home loan. Later, he withdraws some money from the offset account to purchase listed shares, which increases the interest payable on his home loan. However, none of this interest is deductible because the original loan was entirely for a private residence. In this case, Peter effectively used his own savings—not borrowed funds—to acquire the shares.
Parking Borrowed Funds in an Offset Account
We’re seeing more clients set up loan facilities with the intention of using the money for business or investment purposes in the near future. In some cases, they draw down the loan but leave the funds in an offset account while waiting to purchase an income-producing asset. This can create issues when claiming interest deductions.
Even if the offset account is linked to a loan used for income-producing purposes, that alone doesn’t generally make the interest on the new loan deductible while the funds sit in the offset account.
For example, suppose Duncan already has a rental property loan with an offset account attached. He then takes out a new loan intending to buy shares. While waiting, he places the borrowed funds into the offset account, reducing the interest on his rental property loan. In this scenario, Duncan likely can’t claim a deduction for interest on the new loan because the funds aren’t being used to generate income—they’re simply offsetting interest on another loan.
To make matters worse, parking funds in an offset account can potentially “taint” the deductibility of interest on the new loan, even if the money is later withdrawn and used for an income-producing purchase. For instance, if Duncan later uses those funds to buy shares, the ATO might still deny the interest deduction—especially if the offset account already contained other funds before the borrowed money was deposited or if other deposits were made before the withdrawal. This is because it becomes difficult to clearly trace the borrowed funds to the income-producing asset.
Action Points
Before taking on any new loan arrangements, it’s a good idea to speak with us first. In this area, errors can be hard to correct later and may result in unfavourable tax outcomes. That’s why seeking guidance from a tax professional before finalising a loan is so important. We can collaborate with you and your financial adviser to structure the loan in a way that’s both financially sound and tax-efficient.
