Interest on investment rental property loans is generally tax deductible in Australia and for many property investors, it’s one of the most significant deductions available each year; however, the way you use your loan over time can significantly affect what you can claim as a tax deduction.

ATO Taxation Ruling TR 2000/2 explains that it is not the original purpose of the loan that determines tax deductibility, but rather how the loan funds are used at the time of each drawdown or refinance.

Here are three common traps that can cost you your interest tax deduction:

Trap 1: Redrawing for Personal Use (“Tainting” the Loan)

Redrawing money from your investment loan for personal purposes, such as a holiday or your child’s school fees, means that portion of the loan is now considered private by the ATO, and the interest connected to the redraw is no longer tax deductible. This is referred to as “tainting” the loan.

Example:

Marcus originally borrowed $500,000 to purchase a rental property. A few years later, he redraws $25,000 to use for a family holiday. His total loan becomes $525,000 of which only $500,000 is investment related. From that point forward, only 95.24% of the interest on the loan is deductible.

Even if Marcus repays the $25,000 back later, that doesn’t restore the full deductibility of the loan unless the loan is formally split or refinanced. Future repayments of the loan also need to be apportioned between private and investment use, typically on a pro rata basis.

Trap 2: Repaying and Redrawing

Taxpayers often mistakenly believe that after using a loan for investment purposes, they can continue to repay and redraw it without impacting their deductibility. The reality is that the ATO treats each redraw as a new loan, and what matters is how the funds are used at the time, not the loan’s original purpose or what the loan is secured against.

Example:

Marcel borrows a $400,000 loan for the purchase of a rental property. Over five years, he repays $100,000 of principal reducing the balance $300,000. Later, he redraws $50,000 to renovate his private property.

Although it’s the same loan account, the ATO sees this redraw as a new loan for private use, so the interest on that $50,000 is not deductible against her rental property.

Marcel’s loan balance is now $350,000, of which $300,000 is investment related. Therefore, only 85.71% of future interest is deductible against his rental property, and 14.29% is not. If Marcel had used the redraw for rental property repairs, that portion would remain deductible.

Trap 3: Refinancing with Mixed Purposes

Refinancing your loan can also reduce your deductions if you borrow more than needed and use the surplus for private purposes. Only the interest related to the investment portion of the loan remains deductible. The rest must be excluded, even if the entire loan is secured against your rental property.

Example:

Pam has a $300,000 loan for her rental property. She refinances with a new bank and increases the loan to $400,000, using the extra $100,000 to pay off personal credit cards. As a result, only 75% of the interest on the new loan is deductible. The remaining 25% relates to personal use and is excluded as a deduction.

Tips to Maximise your Interest Claim

  • Split your loans: Keep investment and personal borrowings in separate facilities to make apportioning interest easier.
  • Use an offset account: Offset attached to loans reduce interest without changing the purpose of the loan. Withdrawing from an offset does not “taint” the loan like a redraw can.
  • Trace every dollar: Keep clear records of how all borrowed funds were used, especially if you redraw or refinance.
  • Seek advice first: Speak to your accountant at HLB Mann Judd before redrawing, refinancing, or making structural changes to your loan to avoid unintended tax consequences.

This article was co-written with David Ravida, Senior Manager Business Advisory at HLB Mann Judd Melbourne