The 2 broad methods of Debt Recycling

Broadly speaking there 2 ways to ‘debt recycle’.

Debt recycling is the conversion of ‘bad debt’ into ‘good debt’. See http://www.structuring.com.au/terry/recycling-debt/what-is-debt-recycling/

  1. Use the income from investments to pay down non-deductible debt, then borrow to invest further, or
  2. Selling investment assets and using the funds released to pay down the non-deductible debt and reborrowing

The best approach might be a combination of the 2 methods.

Example

Bart has owned a few investment properties for a few years. They are positive geared by $100 per week so that is about $5,200 per year in extra funds he can use to pay off his non-deductible home loan.

But the properties have about $500,000 in equity in them.

Bart only owes $400,000 on the main residence so what he could do is to sell the properties, pay the tax and used what is left to pay off the main residence debt, and to reborrow to buy more properties.

This way he uses a combination of the 2 debt recycling methods.

Of course, there is a lot else for Bart to consider such as, most importantly, his ability to qualify for finance to buy more properties.

Tax Strategy: Use Capital Losses Quickly – Recycle debt + death

Some people have carried forward capital losses. These losses can usually be carried forward until the taxpayer has a capital gain which can ‘soak up’ the capital loss.

I think it is a good idea to use up these losses as soon as possible.

The main reason being that losses are ‘lost’ at death. If the taxpayer dies their loss cannot be passed on to any other person who could utilise it. Don’t lose a loss!

Example

Bart bought a property in a mining town for $1,200,000. He ended up selling it for $700,000 and has a carried forward capital loss of $500,000.

Bart dies and leaves a rental property that he owns to his sister Lisa. The property has a $500,000 capital gain.

Unfortunately, Bart’s loss will not benefit anyone. Lisa will inherit the investment property pregnant with a $500,000 gain, yet she cannot benefit from the loss.

Had Bart sold the investment property before his death he might have made $500,000 tax free and this money could have been passed onto Lisa. He might have even sold the property to Lisa – perhaps with vendor finance if she couldn’t have afforded a loan. Also, if Bart had a flexible will his estate could have sold the property and possibly used up the gain.

Another reason to use up capital losses is their benefits with debt recycling. Making capital gains without needing to pay tax will mean there is more money with which the non-deductible debt can be reduced.


Example of Debt Recycling

Lisa has a $100,000 capital loss from some bad share investments many years ago. Because of this she has a large amount of debt still outstanding on her main residence. But this has not stopped her investing in shares again. She has learnt from her mistakes and is now making some good capital gains.

If Lisa’s shares increased in value by, say $20,000 in the first year, she could sell these shares, pay no tax, and use the proceeds to pay down the non-deductible debt, and then invest in more shares and repeat.

Doing this has 2 advantages

  1. It uses up the loss, and
  2. It produces tax free capital gains which can then be used to pay off the non-deductible debt quicker.

Speak to your tax lawyer or tax agent.

Loan Tip: Overcoming Cash out Restrictions When Buying Main Residence

This strategy is simple yet often overlooked.

Strategy: When buying a new main residence borrow 80% to acquire it, whether you need to or not.

Example

Bart has $400,000 cash and wants to buy a new main residence for $500,000. He plans to borrow $100,000 and then later set up a LOC to invest.

He borrows $100,000 and settles on the purchase. Then he asks for a $100,000 LOC and the bank starts asking questions. Eventually, after giving a DNA sample Bart is approved, but they want a statement of advice from a financial planner saying that Bart will invest in shares.

Lisa is in the exact same situation. Lisa gets some credit and tax advice and borrows $400,000 to buy her main residence. At application stage she splits the loan appropriately so that at settlement she can pay down 2 loan splits and is left with one split with $100,000 outstanding.

  • Lisa had no questions asked about future investment plans,
  • Lisa got the lower main residence rates for all of her splits (prob paying 1% less than Bart),
  • Lisa isn’t incurring any extra interest or costs, and won’t until she draws on the splits, and
  • Lisa has split the loans for tax purposes already.
  • Lisa has saved by not needing to pay a financial planner tosatisfy the lender.

In summary, Lisa has overcome the cash out restrictions and gotten a lower interest rate.

What is ‘Debt Recycling’?

‘Retirement’ can arrive sooner if you can pay off non-deductible debt faster.

Interest on a loan used to purchase the main residence is not deductible – some call this ‘bad debt’. While interest on loans used to purchase investment properties (shares, business etc. too) is deductible – so called ‘good debt’.

So wouldn’t it be good if you could change bad debt into good debt so you increase deductions to save tax and pay off loans faster?

Well, you can!!

As an example, most people would be paying PI on their home loan. The balance would be slowly decreasing. Some would be paying extra on the loan to pay it down faster. If you could reborrow this extra money paying off the loan and then invest it you would be charged around 4% pa in interest. This interest would then be deductible against the income from the investment. If the investment earns more than 4% pa then you would be in front and the extra money received could then be used to pay down the bad debt even faster.

Further reduction of bad debt would potentially mean more funds are available to be borrowed to invest. This in turn would potentially lead to more income to pay off the bad debt which could then be turned into good debt by borrowing again to invest.

If all goes well this could enable the bad debt to be paid off much quicker as the compounding takes effect.

This could be done with property, but most property would end up negative cash flow. But it could also be done with negative cash flow property and just hanging on for a few years and then selling and using the proceeds to pay down the bad debt and then re-borrowing.

You could speak to a licenced financial planner about using shares to do this. Shares are much easier to buy and sell and the costs in and out are very low.

Carefully planned, debt recycling can get you where you want to go sooner.

2018 update – these days owner occupier loans are at a cheaper interest rate than investment loans. Properly structured, debt recycling can allow owner occupied interest rates for investment loans, helping you to recycle a little bit faster still.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au