Deductible and Non-Deductible Interest

Most of us have it. Nearly all of us don’t want it. And yet, it is often fundamental to financial growth in the modern, Australian landscape. What am I? Debt. 

Debt, and the effective use of borrowings enable you to buy assets in today’s dollars that will be valued in tomorrow’s dollar for the period of your ownership of the assets.

You would most likely know is that in the financial world, the interest associated with different types of loans are often categorised into two classes; deductible and non-deductible interest. 

According to Robert Kiyosaki, the author of ‘Rich Dad / Poor Dad’, these two types of borrowings can also be referred to as “good debt” and “bad debt” depending on the type of asset acquired with the borrowings. 

So, what’s the difference? 

“Good debt” that creates deductible interest refers to interest payments  that can be deducted from an individual’s gross income resulting in a reduction in tax payable. This type of borrowing may include assets such as arranging a loan to make investments and produce assessable income.

‘Bad debt’ or non-deductible interest refers to debt where the interest accumulated cannot be deducted from your taxable income. These expenses therefore have no tax benefit.  For example, the purchase of personal assets such as a motor vehicle, or a principal place of residence, or consumer items like an overseas  holiday or ,  can be classified as non-deductible interest. 

Deductible Interest

Take the example of a mortgage on a home. The owner can leverage the interest paid on the primary residence to acquire an investment property that generates assessable income through rental income and a capital gain from the increased value of the property asset. Interest on the loan is tax deductible. 

Non-Deductible Interest

In contrast, securing a loan to purchase a car for personal use will incur non -deductible  interest. This is because the asset is for personal use and does not  generate income or capital taxable appreciation. The interest on such a loan is  non-deductible. 

Is Good Debt And Bad Debt Really Black and White?

One of the  contradictions to the “good debt/bad debt” model is in the case of a home loan where you do not get to claim a tax deduction on the interest paid, but you do get to enjoy a capital gain exemption on the property resulting in the property being  a tax free asset. It is important that if you have both types of debt, deductible and non-deductible debt,  that you split your debt into sub-loans. 

Where To From Here?

Is it also important to note that the key objective is to have as little bad debt as you can, while using good debt to develop your wealth. ‘Debt may be difficult to eliminate altogether but by being aware of these two debt classes, you can better understand where your finances are going in the long term. 

With EOFY approaching, to better understand what type of debt you have and if any of your debt is tax deductible, set up a consultation with our team.

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