IO Loan on IP - Need Clarification

Hey All,
I have been reading about IO loans on investment properties and just needed some help getting my head around it. I posted this on another forum so sorry if you are reading this twice :p

Scenario 1
Let us say I own an IP with a 300k IO loan and a 100% offset account.
Let us say I have 200k sitting in this offset which means I can claim 100k tax deduction on the interest portion of the loan.
I now decide to buy another IP and take 100k from the offset meaning I now can claim 200k of interest tax deductions.
I think that is right so far as all good.

Scenario 2
My question however is let us now say instead of IO on this 300k loan I go P+I with no offset.
Now instead of 200k in the offset I made extra repayments and only owe 100k on my loan so can claim 100k tax deductions exactly like in Scenario 1.
I now decide to buy another IP but now I have no money in an offset account so my only option is to draw the equity from the property which I draw 100k and am now back to 200k which I can claim as an interest tax deduction.

So from how i am viewing this it works out to be the same. Only difference is the hassles of having to go through the banks to draw the equity and I realise this would mean a new valuation and value may have dropped but I am thinking I have this wrong and there are many other considerations??
 
You're kind of focusing on two different things here. The first is P&I vs I/O, the second is the use of an offset account vs redraw. You're on the right track for the deductions, but the reasons are a bit misdirected.

I/O means your loan doesn't reduce over time because you're only paying the interest payments. P&I means the loan will reduce over time because each payment you're paying some interest and you're reducing the principal loan amount. In isolation there's no real tax implications here other than the fact that the interest is tax deductible for an IP, so by reducing the principal (with P&I), you also reduce the interest paid and thus the tax deductions reduce.

Outside of reducing the interest paid (and thus less tax deductions available int he future), that's where the tax deduction difference between I/O & P&I ends in simple cases.

Offset account means you're putting money into a separate account. Whist this changes how the interest is calculated at each repayment, you're not actually paying off the loan, you still owe the same amount. If you put money into the redraw facility instead, this means you're paying off the loan.

If you take money out of an offset account for a second IP, the interest on the first IP increases and thus your tax deductions increase. If you take money out of an investment loan redraw facility for a second IP the same thing happens.

The difference is when one of the properties is not an IP, instead it's you're own home. There's a number of combinations.

Property 1 is your own home, the original loan is not tax deductable. In this case the best solution is not to draw funds from redraw or an offset account, rather set up a separate equity loan for the IP deposit and costs. This may require some additional restructuring.

Property 1 is an IP and you're buying your own home. Here you want to have your savings in an offset account and use your savings for the purchase of your new (non tax deductible) home. Any remaining funds in the offset account would best be moved to an offset account against your new home. You should never use redraw from an investment loan to buy your own home as this contaminates the deducibility of the investment loan (some of the funds are now for investment, some are for your PPOR). If you need to use redraw, you should restructure the investment loan more appropriately first.

Property 1 is an IP and you're buying another IP. In this case you would use funds available in IP1s redraw facilities rather than money saved in an offset account. If you have a non deductible PPOR loan, the offset account should be against that loan, not an investment loan.

The important distinction is that an offset account is for your savings, redraw is for equity. You should avoid mixing your savings and equity if you can. Savings (in the offset account) should be prioretised to non deductible purposes (such as your own home). Equity (funds in redraw) should be prioritized to tax deductible purposes (such as an IP purchase).

These are moderately complex considerations, if you aren't clear on this, you should seek professional advice. Getting it wrong can have a large impact on the tax deductibility of your loans in the future. You are unlikely to receive this advice from a loans officer in a bank branch.
 
but I am thinking I have this wrong and there are many other considerations??

You have it correct, but haven't taken into account other issues.

Say you wanted to buy a new house to live in, or an ivory back stratcher for $200,000.

Under option 1 you could take $200k from the offset and claim the increased interest on the loan, despite the money being use for a private expense.

Under option 2 you would need to borrow to buy the home/scratcher. Because this is a private expense the interest on this loan would not be deductible

At 5% that is a difference of about $10,000 in deductions per year.
 
That now makes total sense! Thank you so much for clarifying this.

Also a note to maybe avoid buying $200,000 ivory back scratchers! haha
 
Sorry I thought I had this but now I have another question :p

So if you own an IP paying P+I then as long as you are redrawing to buy more investments then you will not contaminate the loan?

If you then decide you do want a PPOR and used a redraw you would contaminate the loan but this could be avoided by redrawing into a new equity loan? Or you could instead sell the IP and then use the funds to purchase the PPOR?

Does that sounds correct? Is this the consideration when dealing with this scenario?

The reason I ask because if you have a wife that likes to spend money :p then having the money in an offset is somewhat dangerous. If however it was used to pay principal then it cannot be wasted.

The other consideration I was unsure of is let us say I have a CF+ property of $50 a week. Should that be going back into the loan of the IP or is it best for that to go somewhere else?
 
The loan will end up mixed. Some for ip1 and some for ip2. This won't make tax issues as both will be deductible. But if you decide to move into either property in the future it would be an issue.

$50 cash flow should be placed into any non deductible loan first. Then once you have no more non deductible debt it is a personal choice of whether you pay off investment debt or not.
 
Thanks Terry

Just hopefully one final question. I understand the term "contaminated loan" but could I just ask what affect this does have?

Does it mean an accountant cannot claim any tax deductions from this or does it just mean it is really hard and you risk making mistakes that could upset the ATO?
 
P&I or I/O has no effect on contamination of the loan.

Contamination is primarily dependent on what you use the money in the redraw facility of the loan for. If the loan is original for personal use (buying your own home), further drawings should also be for personal use. If the original loan is for investment use, additional redraws can be to buy other property and the loan won't be contaminated.

What will contaminate the loan is if it was to purchase an investment and you want to redraw to buy your own home. The first is tax deductible (IP purchase) the second is not (PPOR purchase). Instead you should borrow money via two separate accounts so you're very clear on which loan is for investment and which one isn't.
 
Hey Peter and Terry,
Thanks for the help with trying to understand this.

I am still uncertain what affects a contaminated loan has when it comes time to try and claim the deductions though.

Let us say for example I contaminated my loan and mixed an IP with my PPOR and then tax time rolled around. How would i deal with this? Or would i simply be unable to claim any interest deductions on the IP because it was contaminated with non deductible?
 
A contaminated loan is one where it's part deductible part non-deductible. To claim interest on the loan, you need to know how much of the loan is still tax deductible and only claim interest on that part.

It can be rectified by splitting the loan into two parts along the same portions and only claim the split part that's now fully deductible.

The tricky bit is if you mess things up too much, it gets very difficult to determine what the split is and in extreme cases the entire loan may no longer be tax deductible.
 
Thanks Terry

Just hopefully one final question. I understand the term "contaminated loan" but could I just ask what affect this does have?

Does it mean an accountant cannot claim any tax deductions from this or does it just mean it is really hard and you risk making mistakes that could upset the ATO?

A contaminated loan is one which is mixed.

If the loan is PI then it will become even more contaminated as each repayment must come off each portion of the mix.

e.g $100,000 loan
$40,000 for propert A = 40%
$60,000 for property B = 60%

each repayment of principal must come off A at 40% and B at 60%.

So a $100 extra repayment will reduce $40,000 - ($100 x 40% = $40) = $39.960.

Imagine trying to work this out over a few months and then 20 years! Also factor is a repayment of $2000 per month will include an interest portion and a principal portion and this will be changing each month.

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If the loan is IO then it is a simple % split.
 
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