What is the Recycling Debt Strategy?
Recycling debt is the conversion of ‘bad debt’ into ‘good debt’.
Bad debt is debt on which the interest is not tax deductible and it includes loans used to acquire the main residences. Good debt is debt on which the interest is tax deductible. This includes loans used to acquire rental properties and income producing shares. Where the interest on a loan is deductible it makes it so much easier to pay as the taxman is chipping in to help.
For example on a $500,000 loan at 5% pa interest rate the annual interest payable would be around $25,000 (if interest only). If the borrower is able to deduct the interest they would save this amount x their marginal tax rate. For example someone on the top marginal tax rate of 47% (including Medicare levy) the tax saved would be $11,750.
But it is not just about the tax savings. The investment itself may also, hopefully, return more than it costs so it actually puts money into the borrower’s pockets.
These savings/returns can then be used to pay down the bad debt further so that it can be re-borrowed to invest. This slowly creates a compounding effect which gradually speeds up and allows the bad debt to be paid off much quicker than normal.
An example with numbers
Bart has:
$500,000 non-deductible home loan used to buy the main residence.
$100,000 cash savings in an offset account
5% interest rate
IO loan
Bart is currently paying interest on $400,000 because of the offset account. This equates to $20,000 p.a. with none of it deductible.
Bart wants to invest now (for retirement). If Bart uses the $100,000 from the offset account to invest he will now be paying interest on $500,000 with none of the interest deductible. His investment may return 7% or $7,000.
So Bart has an income of $7,000 and non-deductible expenses of $25,000.
However if Bart used the $100,000 to pay his loan down[1] to $400,000 and reborrow the $100,000 to invest in an income producing asset the interest on the $100,000 will now be deductible.
Bart will now, each year
Pay $20,000 in interest which is not deductible.
Pay $5,000 in interest which is deductible, and
Earn $7,000 from the investment.
So Bart has $2,000 in income and $20,000 in non-deductible expenses.
This is a similar outcome to before, but the extra tax deductions would be $5,000 x Bart’s marginal tax rate – let’s use 39% for Bart. Using the Recycling Debt Strategy would mean Bart is $1,950 ahead in the first year.
Bart could the use these tax savings, investment returns and other income to pay down his non-deductible debt further and then re-borrow to invest again.
Over time this will compound and the process will quicken until all of the bad debt is paid off.
‘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 – hence this is known as ‘good debt’.
So wouldn’t it be good if you could change bad debt into good debt?
Well, you can!!
You can do this by using a Recycling Debt strategy.
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. So speak to your tax advisor about using a recycling debt strategy.
See Discussion at: https://propertychat.com.au/community/threads/tax-tip-2-debt-recycling.1472/
[1] Note that Bart should split the loan first for tax reasons. This will be covered in a future post