The Revolving Credit Trap was featured by MortgageLab, 22 February 2021

Revolving merry go round

Revolving Credit can be an excellent tool for both home owners and property investors to reduce interest costs and speed up the repayment of their mortgages, while keeping availability of cash as an emergency buffer or savings towards the next big purchase or investment.

But when it comes to investment lending they come with some pretty nasty tax hooks that can significantly reduce your tax deduction available if you don’t treat them properly.

Please note this is distinct from an Offset arrangement which has a separate, simpler tax treatment but comes with its own version of the trap – a short note on that near the end.

What’s Revolving Credit?

A Revolving Credit arrangement is essentially a large overdraft facility secured against real estate, with a variable (floating) interest rate. As at the time of writing, Bank Revolving Credit rates are between 3.45% and 5.15% – a tiny bit higher than the usual floating rates.

You have a single account with a large “overdrawn” balance, and can pay this down at any time, then draw it back out without having to make a new loan application. Accordingly, you have unmatched flexibility. Some property traders (flippers) use large revolving facilities to buy and renovate a new project outright – avoiding the need to raise short term funding, reducing legal costs and simplifying their trades.

Because you only pay interest on the drawn balance, it’s common (and inherently sensible) advice to put your salary into the account, pay your bills by credit card, and have the card paid from the revolving credit. But therein lies the tax trap. If this is a private mortgage there are no problems, but for an investment mortgage it causes major tax deductibility complications.

In the eyes of the IRD, every time your salary is paid into the account, a portion of the loan is being repaid. When money is drawn back out to pay your credit card or other private expenses, this is new borrowing. As such, if the new borrowing is for private purposes, it’s non deductible. And it taints the whole revolving credit account until the whole thing is repaid! You can’t just pay back the private bit of an account and leave the deductible bit. Consider the example below where deductibility on the revolving loan drops to 33.7% in just 3 years, losing over $5,000 in what should have been legitimate tax deductions.

An Example

Initial Loan drawn 1 April 2019: $750,000.
Fixed: $600,000 @ 3%
Revolving $150,000 @ 4%.

Date Transaction Amount Balance Deductible
01/04/19 Drawdown -150,000 -150,000  -150,000  (100.0%)
15/04/19 Salary 8,000 -142,000  -142,000  (100.0%)
01/05/19 Interest on Revolving -487 -142,487  -142,487  (100.0%)
01/05/19 $600k Loan Payment -1,500 -143,987  -143,987  (100.0%)
15/05/19 Salary 8,000 -135,987  -135,987  (100.0%)
20/05/19 Credit Card Payment -5,000 -140,987  -135,987  (96.5%)
01/06/19 Interest on Revolving -470 -141,456  -136,440  (96.5%)
01/06/19 $600k Loan Payment -1,500 -142,956  -137,940  (96.5%)
15/06/19 Salary 8,000 -134,956  -130,220  (96.5%)
20/06/19 Credit Card Payment -5,000 -139,956  -130,220  (93.0%)
01/07/19 Interest on Revolving -466 -140,422  -130,654  (93.0%)
… Continue for 8 months …
01/03/20 Interest on Revolving Credit -438 -132,026  -92,648  (70.2%)
01/03/20 $600k Loan Payment -1,500 -133,526  -94,148  (70.5%)
15/03/20 Salary 8,000 -125,526  -88,507  (70.5%)
20/03/20 Credit Card Payment -5,000 -130,526  -88,507  (67.8%)
01/04/20 Interest on Revolving -435 -130,961  -88,802  (67.8%)
End of Year 1: Revolving Credit Deductibility 67.8%; Lost Tax Deductions: $921
… Continue for 2 years …
01/03/22 Interest on Revolving -350 -105,454  -36,319  (34.4%)
01/03/22 $600k Loan Payment -1,500 -106,954  -37,819  (35.4%)
15/03/22 Salary 8,000 -98,954  -34,990  (35.4%)
20/03/22 Credit Card Payment -5,000 -103,954  -34,990  (33.7%)
01/04/22 Interest on Revolving -346 -104,300  -35,107  (33.7%)
End of Year 3: Revolving Credit Deductibility 33.7%; Lost Tax Deductions: $5,817

Avoiding the Trap

So, how can you avoid the revolving credit trap described above? There are three primary ways:

  1. Don’t plan to withdraw from the RC for personal reasons (poor result, pay excessive interest)
  2. Have a separate, smaller RC for the salary and credit card transactions, and only transfer money into the main RC when you’re not expecting to need it for private purposes (poor result, unnecessary complexity, easy to stuff up)
  3. Ownership of the property and associated debt in a different structure – an ordinary company, LTC, or Trust. By owning property and debt in another entity that owes you money (speak to your accountant to be sure, or contact me!), any borrowings for private purposes are simply a repayment that debt owed – rendering the whole revolving credit trap irrelevant.

What about Offsets?

An offset account operates similarly, but is distinct from revolving credit because it is made up of two separate accounts – a loan and a positive-balance savings account). Because of the distinction it is treated differently for tax purposes.

Having money in the savings side of the offset account reduces the total amount of interest you pay, but doesn’t change the underlying nature of the debt. If the initial loan was related to the rental, your contributions to the offset account can be withdrawn freely and the rental debt simply charges you more interest again.

This however can catch you when you have an offset account on your personal home, and then use the savings to buy an investment property – there is no new debt, you’re simply paying more money on your owner occupied mortgage again.

In conclusion, revolving credit and offset accounts provide excellent flexibility and a sensible place to park your money when you may still need access to it in future. But be aware of (and ideally avoid) the complications described above through good conversations with your accountant and your mortgage broker.