Investment Loan Interest Deductibility: Getting the Structure Right

Most investors assume their loan interest deduction is settled the day they sign the mortgage. It is not. The ATO looks at what the borrowed money is used for, not what secures the loan, and that use can change over the loan's life. A single redraw for a private purpose, or a poorly structured refinance, can quietly reduce a deduction an investor assumed was intact.

The core test: what the money does, not what backs the loan

Under section 8-1 of the Income Tax Assessment Act 1997, interest is deductible to the extent it is incurred in producing assessable income. The ATO applies a use test: the character of the interest follows what the borrowed funds were used for, not the taxpayer's intention.

The ATO makes the security point explicitly: a couple secures a new loan against their existing home to buy a new home, then rents out the original property instead of selling it. Interest on the original mortgage is deductible because that property is now rented; interest on the new borrowing is not, even though secured against the rental property, because the new home earns no income. Security is irrelevant, which is why redrawing against a paid-off rental property to buy a car does not become deductible just because the property backs the loan.

Mixed-purpose loans: why one private drawdown taints the account

Problems start when one loan account funds both the rental property and something private: a car, a holiday, school fees. Under Taxation Ruling TR 2000/2, this creates a mixed-purpose account and interest must be apportioned; repayments cannot be nominated against one portion, they reduce both proportionately. The ATO's own example: a $400,000 loan, $380,000 for a rental property and $20,000 for a car, $35,000 total interest for the year.

• Total interest x (income-producing balance / total balance) = deductible interest
• $35,000 x ($380,000 / $400,000) = $33,250 deductible

That ratio then applies to interest and principal for the life of the loan. TR 2000/2 allows two narrow exceptions: recouped funds repaid into the account reduce only the portion previously applied to that use, and refinancing into two separate accounts matching the original amounts keeps each portion's character. Outside those, apportionment sticks for good.

Offset or redraw: the distinction that decides whether the deduction survives

An offset account is a separate deposit account. Under Taxation Ruling TR 93/6, an acceptable offset arrangement nets that deposit balance against the loan to reduce interest, without reducing the loan's principal or paying the depositor interest on the deposit. Because it is a separate account, withdrawing from it is a withdrawal of your own savings, not a borrowing, so it cannot change the character of the loan's interest. Spend the offset funds on a holiday and the loan's interest stays fully deductible: the loan itself was never touched.

A redraw facility is different: it does not touch a separate account, it draws the loan balance back up. TR 2000/2 calls a redraw "a new borrowing of funds", regardless of what the original loan was for. Redraw $10,000 from an investment loan for a car and that $10,000 becomes a private borrowing inside an otherwise deductible loan, mixed-purpose from that point on. The ATO's own example: an investor redraws $9,500 from a rental loan for a TV and lounge suite, apportioning the loan roughly 97.4:2.6, recalculated monthly for as long as the loan runs.

Refinancing and drawing extra equity

Refinancing does not reset the deductibility clock. A new loan used to repay an existing one stays deductible to the extent the original was income-producing, so moving a clean investment loan to a cheaper lender is not itself a risk.

The risk is releasing equity. If part of a refinance pays out the existing investment debt and part funds something private, a second property, a business venture, debt consolidation, that private slice is treated like a private redraw: not deductible, and the loan again becomes mixed-purpose. The fix is to split the refinance into genuinely separate accounts at settlement, one for the investment debt, a distinct facility for the private drawdown, mirroring TR 2000/2's exception for matching separate accounts, keeping the investment split clean.

Keeping the deduction clean

• Never redraw from an investment loan for a private purchase; use an offset account or a separate personal loan instead.
• Ask a lender to split one facility into separate accounts from the outset, one per purpose.
• Keep records showing what every drawdown and redraw was used for: the onus is on the investor to prove it.
• Before refinancing or releasing equity, work out the split in advance, not after.

We work through structuring like this with clients before they draw a single dollar, not after a tax return has locked in a bad outcome. If you're planning a purchase, refinance or equity release, our property investor services page has more on how we help clients get it right from the start.

Disclaimer: This article contains general information only and does not constitute financial, legal or tax advice. It has been prepared without regard to your objectives, financial situation or needs. Tax and superannuation laws change frequently, and the information in this article may not reflect the current law or may become inaccurate over time. Before acting on anything in this article, you should consider its appropriateness to your circumstances and seek advice from a registered tax agent or qualified adviser.