Debt recycling is a tax effective strategy that focuses on shifting the balance of non-tax deductible debt towards a tax deductible loan. This strategy is popular with those who have paid off some of their home loans and are looking to diversify their investments away from the family home.

Just like what we do at home, recycling involves organising debt from what we don’t want into a ‘tax-effective’ bucket we do want. Unfortunately this strategy won’t save the environment, but it should save investors tax.

High income home owners

Debt recycling is practical strategy for investors who are:

• Focused on paying off an existing loan against the family home
• Looking for tax effective ways to build wealth over the long term
• Seeking to diversify their overall assets outside of residential property
• Looking for a tax deduction against their high income

Why this approach has distinct advantages

The advantage of using your home equity as security instead of other assets (like listed equities or investment properties), is that an owner-occupied residential property has historically been one of the least volatile assets against which to secure a loan.

The intangible benefit is that – unlike equities – there is a significantly lower risk of a ‘margin call’ in times of market or economic volatility. Loans secured against a residential asset are rarely – if ever – revalued (especially down) over the course of a loan.

Shifting your ‘interests’

The interest on the loan supporting the investment is tax deductible against the assessable income. In essence, the higher the taxable income, the more valuable this strategy becomes. This approach allows you to continue to direct all surplus cash flow towards the home loan and allow your investment portfolio to continue to grow.

The process can result in a more rapid increase in deductible debt and reduction of non-deductible debt a.k.a. good vs bad debt. Home loans are usually thought of as good debt, but it is not an ‘income producing’ asset therefore cannot be deducted against your income.

Considerations

This strategy is generally appropriate for clients who have strong cash flow and are interested in long term capital wealth creation by investing ‘growth’ assets which may include equities or property. This investor would likely have a growth risk profile as the strategy involves gearing and comes with a longer time horizon.

In order for debt recycling to be effective and worth considering, one should have:

• A long term investment strategy of at least 5-7 years
• A regular, independent income that is reliable
• A high income and equity in a property
• Income protection and life insurance in place
• Cash flow buffer (Offset Account) to absorb any unforeseen cash flow changes

Case Study

You have a $500,000 home loan and $500,000 cash. You have the option to either invest the cash into the portfolio, or pay off the home loan and then create a new loan to fund the investment of the portfolio. The two options would have the following impact on your situation:

As you can see from the above, the creation of tax deducible debt, over non deducible debt has improved the client’s situation by approximately $7,050 per annum.

Is this appropriate for you?

We strongly urge even experienced high-income earners to seek professional advice before implementing this or any similar strategy. Outside of one’s own personal circumstances, the investor should consider other risks that exist which may include how interest rate movements or poor investment performance could impact your outcomes. In more extreme situations, results could lead to financial stress.

Always seek advice if any tax or investment strategy is being applied to your specific circumstances.