This tax season, individuals are asking whether the interest on a loan can be claimed as a tax deduction. It’s an important concern since the treatment of interest expenses can have a significant impact on your overall tax situation. However, the rules surrounding this can be complex. Here’s what you need to know.
The Purpose of the Loan
It’s essential to understand how the borrowed money is used to determine the tax treatment of interest expenses. In other words, why did you take out the loan? For interest expenses to be deductible, you generally need to demonstrate that the borrowed funds were used for business purposes or other income-producing activities. The collateral used for the loan is not relevant in assessing the tax treatment.
Redraw vs Offset Accounts
Even though these arrangements might look similar in terms of how they affect your finances, the tax rules treat them very differently. This is an area where you must be cautious. If you have a loan account and you have paid off part of the loan, then later take money out again using a redraw facility, this is considered a new loan. At that point, the key rule is applied to check out how it’s treated for tax purposes: what are you using the redraw money for?
On the other hand, an offset account works differently. Money in an offset account is treated more like your own savings. Taking money out of an offset account is not considered borrowing, even if it causes you to pay more interest on the linked loan. Because of this, you must look back at what the original loan was used for to understand how it will be treated for tax purposes.
Using Borrowed Funds in an Offset Account
It has been seen that clients set up loan facilities to use the borrowed funds for future business or investment activities. In some cases, clients withdraw funds from the facility and leave them in an existing offset account while waiting to buy an income-generating asset. However, this approach can result in complications when claiming interest deductions. Even if the offset account is linked to a loan used for income-generating purposes, this alone is not enough to make the interest on the new loan deductible while the borrowed funds remain unused in the offset account.