This snippet is from one of our previous episodes: The Overlooked CGT Timebomb Hidden in Joint Tenancy.

Debt recycling is one of those strategies that sounds clever in theory… using the equity in your home to invest and “convert” non-deductible debt into deductible debt. But as our resident tax expert Julia explains, that’s where many investors get caught out.

In this TPC Gold episode (from one of our most popular Q&A sessions), we unpack:

  • What debt recycling really means, and what it isn’t
  • The key lessons from the famous Hart case that still apply today
  • Why “interest on interest” deductions can trigger serious ATO red flags

If you’ve ever wondered whether debt recycling is a smart strategy or a risky tax play, this is a must-listen.

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If You Enjoyed TPC Gold | ATO Crackdown: The Truth About Debt Recycling, You Might Also Like:

Transcript

Ben Kingsley
Debt recycling. A lot of people have different views about what debt recycling is. And a couple of months ago, Bryce, we talked about it on the pod. But Julia, in terms of the common definition that you had for debt recycling, why don’t we start there in terms of what most people talk about and what we think it is, and then we’ll just branch off from that and have a bit of a discussion around debt recycling?

Julia Hartman
Well, it’s interesting. When we first talked, we all three of us had sort of a different definition of what it is. And the basic idea is using equity in your home to invest. No problem with that as long as the loan’s set up right. But I’m very suspicious of some of the times I hear the word debt recycling used and it implies that you can turn non-deductible debt into deductible debt. So that’s what concerns me. And what people need to understand (is that) you can’t do that through debt recycling. And I’m worried that it’s dressed up as something like that (where they) don’t actually say it, but you think that’s what you’re getting into when you get into these products. If they say it, then the ATO’s got them… dominant purpose of a tax benefit or they’re getting you into products that you’ve got to buy or higher interest rates. It really worries me when I hear the word.

Bryce Holdaway
So you’ve spent a lot of time unpacking some of these rulings and the ideas and some of these concepts that come along with it, so it would be fair to say that you’re the person who is always bringing a calm approach to it, and you’re also armed with Part IVA which we’ll talk about shortly. But I remember Julia when I first got into the gig… 1998, so I was 23. I remember it was buzzy. We used to get together, and we thought we had this little underground sort of movement going on where let’s see if we can outsmart the tax department. Let’s see if we can turn some stones over that no one’s ever turned before. But I think now having been involved in it for (this is now my third decade), it’s fair to say that Part IVA is the ATO’s weapon for any little underground groups that are trying to outsmart them, right?

Julia Hartman
Yeah, it’s all about the dominant purpose. And if the dominant purpose is to get a tax benefit (in other words increase your tax deduction), well, it’s to avoid the tax office. Many years ago, there used to be a bit of an argument that the dominant purpose is to pay your home loan off sooner. But that didn’t fly. So yeah, it’s basically strict nexus. What was the money borrowed used to buy? And if you can’t repay that loan because you’ve lost your job and you have capitalized interest or something like that (and) borrow elsewhere to pay, then that’s all right, because it’s not the dominant purpose of the tax benefit. It’s just to get the debt paid off. But when you get to a strategy that is marketed and structured to increase the debt that’s deductible… your dominant purpose is that tax deduction for the interest, isn’t that so?

Ben Kingsley
That’s right Julia. And I think for the community who don’t know Julia’s backstory… Julia has been around. She’s been a leading tax specialist in Australia for decades in this space. She’s written a couple of great books on this topic. And in one of those books you were referencing when there was a ruling around when interest was deductible and interest on interest and those types of things. So why don’t you tell us the little backstory in terms of what was originally a ruling and then what has changed? Because you gave us a little clue in what you were just talking about then.

Julia Hartman
Yeah. Well, Hart’s case is the case, and I think there were three cases and the ATO kept on losing so they used the unlimited taxpayer funded fighting fund and they just kept appealing until they won. But in the end at one stage, one of the judges even said, well, what sane person wouldn’t pay off their home and delay paying off their investments? But in the end, with the pride of a poker player with a full hand, they went to court the final time and said, all right, we admit it: capitalized interest is tax deductible. Part IVA there’s a pamphlet for this loan that said do it for the tax benefit. So the dominant purpose is a tax benefit. So you’ve lost it. So yes, capitalized interest is deductible. But only when you can say that it’s for a reason other than the tax benefit.

Ben Kingsley
So here we are talking with our tax accountant; this is fun for Bryce and I in terms of having these conversations. So this is why we want to go off on these little threads and have these little extra conversations. So based on the original dominant purpose, which is I wanted to pay my home loan off first, that was then squashed as well. Because for a period there that was my dominant purpose… is I want to pay off my home loan and then eventually, to your point, the ATO kept pushing, pushing, pushing. When roughly was that that? Because I still hear people out in the street and spruikers and all of that talking about the Hart’s case, and you can claim interest on interest, and you can do this debt recycling, and those types of things. So roughly, when was that? Because it is important to start getting that message out into the community that sometimes the tax laws change.

Julia Hartman
Well, we’re talking about around the year 2000. Thanks for that question without notice, Ben.

Bryce Holdaway
Welcome to my world, Julia.

Ben Kingsley
And so to your point, if you’re effectively trying to increase your deductible debt to pay off your home… in other words, the rent that’s coming from your investment properties is fast tracking you paying down your principal place of residence, i.e. your non-deductible debt, and you’re letting your debt increase, and then you’re trying to claim the interest on that interest to accelerate that debt payment down… that’s also been squashed as well, hasn’t it?

Julia Hartman
That’s right. That is a scheme. That is an arrangement with the dominant purpose of a tax benefit, isn’t it?

Ben Kingsley
Yeah.