Offset vs Redraw: What An Expat Needs To Know About Debt Structuring – with interest rates rising to a 10-year high in Australia, Australian Expats with leveraged investment properties may have thought about temporarily paying down debt to mitigate higher interest costs.
This is often prompted by receiving a large lump sum of cash from a recent windfall, bonus, inheritance, or even the sale of another property.
But what’s the smartest way to do this effectively?
In this article, we discuss the nuances of an expat using an offset account versus a redraw facility when it comes to effectively paying down debt and explain how in some instances, using one over the other could potentially leave you significantly worse off and forgoing years of tax benefits.
How do Offset Accounts and Redraw Facilities work?
Most lenders in Australia will afford borrowers with either an offset account or a redraw facility feature (or both).
In essence, both features allow the borrower to reduce their outstanding loan balance (the principal), but in different ways:
- Offset account: Funds deposited in an offset account are used to “offset” the outstanding loan balance, which results in a reduction in interest costs. For example, a borrower with a $500,000 loan and $100,000 deposited in a linked offset account is only subject to interest on $400,000 (i.e., $500,000 – $100,000) rather than the entire loan amount of $500,000.
- Redraw facility: Funds paid into a loan’s redraw facility are considered a repayment of the original loan, and therefore the amount paid in will reduce the outstanding loan balance accordingly. The funds are then available to “redraw” as cash should the borrower require the funds at a later date. What’s critical to understand is that any deposit made to a redraw facility is seen as a permanent repayment of the loan, and any redraw from the loan is seen as new borrowings (a new loan).
Which option is best for temporarily paying down debt?
I have referred to paying down debt as temporary because, under either feature (offset or redraw), the funds can still be accessed again in the future if required.
However, the conditions around accessing these funds in the future are considerably different depending on whether they come from an offset account or a redraw facility. Let’s take a look in more detail.
For most Australian Expats, their real estate assets are rented out for rental income, which consequently creates taxable income in Australia.
Australia’s tax law permits the costs incurred in renting out the asset to be claimed as a tax deduction to reduce a person’s taxable income. These costs incurred include the interest expense of the loan.
Therefore, it’s paramount to ensure that any new loan arrangement entered into in the future continues to allow for the interest expenses to remain tax deductible.
This requires an understanding that:
- For a loan’s interest to be tax deductible, the borrowed funds must be used in purchasing an income-generating asset (e.g., an investment property, but not a main residence).
- It is not the security for the loan that determines the deductibility of that loan’s interest.
This is best illustrated through a worked example.
Example of An Expat Managing Their Debt
Peter is an Australian expat and plans to return to Australia in 12 months’ time. He would like to purchase a new main residence (MR) in Brisbane once he returns home.
He has recently sold one of his two Australian investment properties (IP) and is left with $500,000 in cash after taxes. He owns another IP in Melbourne he plans to keep which currently has an outstanding loan of $600,000 with a redraw facility available, but no offset account.
The interest rate on this loan is 5% and is interest only. What should Peter do now with the $500,000 to reduce his interest costs?
Scenario 1: What Peter shouldn’t do.
Peter decides to place $500,000 in the redraw facility on the outstanding loan of his Melbourne IP, saving him $25,000 in interest over the next 12 months ($500,000 x 5%).
This $500,000 is also available in the redraw facility should he need it in the future.
Peter returns to Australia in 12 months and decides to buy a new MR in Brisbane for $1M. To buy the new MR, he uses the $500,000 in the redraw facility as the deposit (this is considered a new loan) and then borrows the remaining $500,000.
Peter now has 2 separate loans of $500,000 on his new MR in Brisbane. Because the property in Brisbane is Peters’ MR, he cannot claim the interest expense on either loan as a tax deduction.
By placing $500,000 in the redraw facility 12 months ago instead of an offset account (or high-interest savings account), Peter now has a substantial loan ($1M) on a non-deductible asset (the MR in Brisbane) and only a small loan ($100,000) on a deductible asset (IP in Melbourne).
Scenario 2: What Peter should do.
Peter should have instead opened an offset account linked to the $600,000 investment loan and placed the $500,000 into the account to offset the loan for the next 12 months (still saving $25,000 in interest).
Upon returning to Australia, he would have used the funds in the offset account to purchase the new MR because the cash in the offset account is not seen as a new loan.
Once Peter uses the $500,000 in the Offset account, he again has a $600,000 loan on his Melbourne IP and can claim the interest as a tax deduction. Peter also avoids the issue of having a mixed loan (not discussed here).
Comparing the numbers
To put this comparison into context, let’s assume Peter was earning an income of $250,000 per annum when back in Australia. His marginal tax rate is therefore 47% (45% plus 2% Medicare levy).
We then want to know the tax benefit gained/lost on his Melbourne IP. Assuming the interest rate on the IP loan remains at 5% and is interest only, the tax savings between the two scenarios is as follows:
|Scenario 1||Scenario 2|
|Property||Melbourne IP||Melbourne IP|
|Tax Deduction||$5,000 (100,000 x 5%)||$30,000 (600,000 x 5%)|
|Marginal Tax Rate||47%||47%|
|Tax Saving (each year)||$2,350 (5,000 x 47%)||$14,100 (30,000 x 47%)|
In Scenario 2, Peter saves an additional $11,750 in tax each year (14,100- 2,350) for as long as he continues with this loan arrangement. The tax saving increases to $58,750 after 5 years (11,750 x 5).
The above discussion highlights how making what may seem to be a sound financial decision on the surface (i.e. paying down debt) can inadvertently leave you considerably worse off from a tax perspective in the future.
Debt structuring is a complex area and being able to implement strategies effectively requires consideration of your anticipated goals and objectives for the future.
Should you wish to learn more about debt structuring strategies and how they might be useful to your situation, please feel free to reach out to us through the contact tab on our website and speak to one of our licensed Financial Planners.