In this month’s article JULIA HARTMAN, the Founder of  BAN TACS – National Accountants Group explains how property investors can easily trip themselves up tax wise if they are not fully aware of how the offset account against their investment loan works. 

Offset accounts are certainly a great idea if you want to temporarily reduce a debt that is either tax deductible or will be in the future.

You see if you pay down a deductible debt and then redraw for private purposes, the interest on the redraw will no longer be tax deductible because it was used for private purposes.

An offset account, being a separate account avoids this problem, because the original loan balance is not reduced.

The bank just agrees to only charge you interest on the difference between the total loan and the amount sitting in the offset account.  An offset account has the same effect on the interest you pay without a permanent reduction in the loan balance. 

The basic rule is – what the borrowed money is used to buy determines whether the interest on the loan is tax deductible.

The link between the borrowing and the expenditure is called the nexus, and the nexus needs to be very clear.

You need to be able to show exactly how the money borrowed was used to purchase an asset that is producing income. For the interest on a loan to be tax deductible it must be a cost of earning taxable income.

The danger with offset accounts is that funds withdrawn from the loan and placed into the offset account can lose that nexus with the loan, if they sit there too long or are mixed with other funds.

A principle established in Domjan’s case is that once borrowed funds are mixed with private funds the nexus is lost. 

Let’s look at the Domjan Case:

Wilma Domjan withdrew money from her loan, deposited it into her cheque account and then wrote cheques to pay for work done on her rental property.

In all but one case there were already private funds sitting in the cheque account. The court ruled the nexus between the borrowings and the rental property was lost.

The borrowed funds were mixed with private funds so the borrowings were for private purposes, no tax deduction on that portion of the loan interest.

There was one exception, when she drew money from the loan account and deposited it into her cheque account, there were no other funds in the cheque account at the time of the deposit, right through to when the cheque, for rental property repairs cleared.

In the Domjan case the court decided that the borrowing was for tax deductible purposes.

Your options:

Accordingly, you may get away with drawing loan funds down into an offset account to very promptly pay for a tax deductible expense if the account has nothing else in it during that time. Don’t let the money sit around while, say you look for a property, just in case the ATO views them as having become savings.

Further, do not deposit anything else in that account while the borrowed funds are there, not even rent and certainly don’t draw on it for private purposes, not even a little.

Don’t think that good record keeping will help. Wilma Domjan was commended on her record keeping.

Final word:

The safest option is to pay tax deductible expenditure straight from the loan account and never put borrowed funds into an offset account.

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Julia Hartman is the founder of the BAN TACS National Accountants Group which has offices on the east and south coast of Australia, from Mackay to Adelaide.

General Advice Warning: This blog is not designed to replace professional advice. It has been prepared without taking into account your objectives, financial situation or needs. You should consider the appropriateness of the advice, in light of your own objectives, financial situation or needs before making any decision as to what is appropriate for you.  

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Accounting Offset Accounts – How Investors Can Avoid Tax Dangers