How Property Investors Can Maximise Tax Benefits with Interest-Only Loans: Depreciation Schedules and Deduction Strategies
Experienced investors know, true profitability of an investment property requires effective tax management strategies.
One of the legitimate strategies to optimise tax outcomes is by using interest-only loans combined with strategic use of depreciation schedules and deductions.
We will explore:
• The tax implications of different loan structures for investment properties
• How to maximise deductions using interest-only loans
• Sample calculations across income brackets
• Tips for structuring loans for optimal tax outcomes
Understanding Loan Structures: Interest-Only vs Principal-and-Interest
When financing an investment property, Australian investors generally have two main loan repayment options:
Principal-and-Interest (P&I) Loans
You repay both the loan interest and a portion of the loan principal each month. While it builds equity faster, it also means higher repayments and a lower annual interest deduction.
Interest-Only (IO) Loans
You pay only the interest on the loan for a fixed period (usually 1 to 5 years). This reduces your repayments and maximises deductible interest, often leading to better cash flow in the short term.
Key Tax Difference:
• Interest payments on investment property loans are fully tax deductible.
• Principal repayments are not deductible.
Hence, an interest-only loan allows a higher proportion of the total repayment to be claimed as a tax deduction.
How Interest-Only Loans Maximise Tax Benefits
1. Higher Tax Deductions
Since only interest is paid, the deductible expense remains higher compared to a P&I loan, where part of each repayment goes towards the principal (non-deductible).
2. Cash Flow Management
• Lower repayments improve cash flow, allowing investors to:
• Reinvest in additional properties
• Fund property improvements (potentially leading to higher rents)
• Build liquidity to weather unexpected costs
3. Strategic Use of Negative Gearing
When the interest and other expenses exceed rental income, the loss can be offset against other income (e.g., salary), reducing your taxable income. Interest-only loans enhance the size of this negative gearing benefit.
Important: This strategy works best if the property is expected to grow in value, offsetting the slower repayment of the loan.
Depreciation Schedules: A Hidden Booster for Deductions
Many Australian investors fail to fully leverage depreciation schedules. Prepared by a Quantity Surveyor, a depreciation schedule itemises:
Capital works deductions (structural improvements like walls, roofing)
Plant and equipment deductions (e.g., appliances, carpet, blinds)
By claiming depreciation, you can significantly boost your annual deductions — often by thousands of dollars.
Example:
| Property Type | Annual Depreciation Estimate |
|---|---|
| New Apartment | $6,000 - $12,000 |
| 5-year-old House | $3,000 - $7,000 |
| 10+ year-old House | $1,500 - $4,000 |
Source: BMT Tax Depreciation
Combining maximum interest deductions with full depreciation claims creates an even stronger negative gearing position.
Sample Calculations: Interest-Only vs Principal-and-Interest
Scenario
• Loan Amount: $600,000
• Interest Rate: 6.0%
• Rental Income: $550 per week ($28,600 p.a.)
• Depreciation: $7,000 p.a.
• Other Expenses: $5,000 p.a.
1. Principal-and-Interest Loan (25-year term)
• Monthly Repayment: ~$3,866
• Annual Interest Paid (approx first year): ~$35,500
• Principal Paid (first year): ~$11,000
• Tax Deductible Amount: Only the interest is deductible = $35,500.
2. Interest-Only Loan (5-year IO period)
• Monthly Repayment: ~$3,000
• Annual Interest Paid: ~$36,000
Tax Deductible Amount: All repayments are interest and thus deductible = $36,000.
Comparing Taxable Positions - table
Result:
| Principal & Interest | Interest-Only | |
|---|---|---|
| Rental Income | $28,600 | $28,600 |
| Expenses (Non-Interest) | $5,000 | $5,000 |
| Depreciation | $7,000 | $7,000 |
| Interest Deduction | $35,500 | $36,000 |
| Taxable Loss | -$18,900 | -$19,400 |
The investor can claim an extra $500 taxable loss annually with an IO loan.
Tax Refund Impact (Assuming Income Bracket)
• $120,000 salary (37% marginal tax rate + 2% Medicare Levy):
Extra $500 loss → ~$195 more tax refund per year.
• $250,000 salary (45% marginal tax rate + 2% Medicare Levy):
Extra $500 loss → ~$235 more tax refund per year.
Over five years, that's nearly $1,000 extra tax back just from structuring the loan correctly — without considering compounding benefits like re-investing the tax refunds.
Structuring Loans for Maximum Benefit
1. Correct Purpose of Borrowing
The ATO requires that the purpose of the loan determines its deductibility. Always ensure the funds borrowed are directly linked to an income-producing asset.
2. Offset Accounts for Flexibility
If you are concerned about rising rates post-IO period, maintain an offset account. You can park surplus cash in the offset (reducing your interest cost without reducing your deductible debt).
3. Separate Owner-Occupied and Investment Loans
Mixing personal (non-deductible) and investment (deductible) borrowings can create messy tax situations. Keep loans clean and purpose-specific.
4. Reassess Regularly
Tax laws, personal circumstances, and market conditions change. Review your loan structures, deductions, and strategies with a mortgage broker and tax advisor annually.
Key Risks and Considerations
• Higher Long-Term Costs: Eventually, paying only interest delays principal reduction, possibly costing more long-term.
• Loan Rollover Risk: After the IO period ends, repayments jump as P&I kicks in.
• Tax Changes: Always watch for government reforms (e.g., changes to negative gearing).
Hence, interest-only strategies work best for:
• High-income investors seeking tax minimisation
• Short-to-medium-term cash flow maximisers
• Investors confident in future capital growth
Using an interest-only loan strategically can significantly enhance a property investor's tax deductions.
When paired with a thorough depreciation schedule and smart structuring, investors can unlock thousands of dollars in tax savings over the investment period.
However, like all strategies, it requires careful planning, ongoing review, and professional advice.
Note, this article is for information purposes only. Always consult your tax specialist before implementing an interest-only strategy to ensure it aligns with your broader financial goals.