A client called me recently and said: “What happens when if I park some excess funds in my investment property’s mortgage offset account? I only get to deduct interest on the smaller mortgage balance going forward, right?“
It seems counter-intuitive, but this is not how it works…
Let’s first look at some basics.
What is an Offset Account and how does it work?
An offset account is a transaction account linked to your home or investment loan. Its real objective is to reduce the amount of interest you are charged, and if you are financially disciplined, it can be quite an effective tool in reducing the term of your loan.
The offset account as the name implies, will offset the balance that you have in the account against your mortgage. Typically being more effective with larger balances, the offset account is deducted from your principal prior to your interest being calculated.
Given that your interest rate is calculated daily, you can usually estimate the interest savings an offset account can give you.
Let’s look at this example below:
Suppose you have an offset account balance of $100,000 each day of the year at an 8% annual interest rate. This will equal interest saving of $8,000 per annum – essentially increasing the proportion of your repayment and potentially helping you pay out your loan a lot sooner.
$100,000 x 8% = $8,000 savings pa
Now, let’s look at more of the questions commonly asked in relation to Offset Accounts.
Q. How are these interest savings treated for tax purposes?
For mortgages related to the family home, or to fund private expenditure like a holiday house, there is no effect. These are private expenses and do not qualify for a deduction. However, if you are using an offset account to produce income such as rent or dividend income, you might be wondering about the interest deductions you are entitled to claim.
You may also want to know if the full interest expense on the property mortgage is claimable as a deduction, or if it is limited to the net interest actually paid with the use of the offset account?
Well the answer is that any interest charged on the mortgage account would be determined on the net balance. This is covered by the taxation ruling 93/6, whereby the interest deductions on such dual account arrangements are limited to the reduced amount of interest you have actually paid.
To illustrate this, say you have a loan amount of $2million linked to an offset account balance of $500,000. This would mean that interest changed and therefore deductible would be calculated on the net $1.5million.
Q. What happens if the Offset Amount is withdrawn? Does the interest deduction revert to a deduction based on the full principal or the reduced net principal?
In the event where you choose to withdraw the funds from the offset account, the interest charged on the mortgage will increase, the whole of the interest on the loan account or principal would still be deductible and won’t be treated as a repayment or a subsequent use of loaned funds for another purpose.
Q. What would happen if the funds were used to pay off the mortgage?
This is quite a different outcome to paying off the mortgage directly as in this instance, the interest on the repaid amount is lost forever as a deduction against the original income producing asset.
Q. What’s the best use of a Mortgage Offset Account to maximise tax deductions?
This is a great example for most people of “We don’t know what we don’t know” and is the reason why you pay us the big bucks for tax advice. For example, you will do well to seek our help if you are considering a scenario of paying $500k off the mortgage directly, or paying that amount into an offset account. Your decision will result in two very different tax consequences!
Call before you sign
Something we always say at Fraser Scott & Co, is to contact us before signing anything or making any big decisions. Remember, a single phone call might save you thousands in unnecessary tax payments.
If you would like to find out more about our services, visit us at www.fraserscott.com.au or click here to read “Why you should talk to your accountant before signing anything”