Kalaro Guides · Investment & Property Tax
Debt Recycling: Converting Non-Deductible Debt Into Deductible Debt
A home loan and an investment loan can be the exact same debt, taxed completely differently. This is how the conversion works, what TR 2000/2 requires, and where joint loans need a formal written agreement to hold up.
What debt recycling actually does
Interest deductibility never depends on which account the money came from. It depends entirely on what the borrowed money is used for. A home loan is not deductible because your home isn't income-producing, not because of anything about the loan itself.
Debt recycling uses this principle deliberately, converting non-deductible debt into deductible debt without increasing what you owe overall. You pay down part of your home loan, then redraw that same amount and use it to buy income-producing assets, typically shares or an investment property. The portion redrawn and invested becomes tax-deductible for the life of the loan, provided it stays invested in income-producing assets.
This is a different move to leveraging (borrowing to invest), which increases your total debt and therefore your risk. Debt recycling keeps your total loan balance the same. You already had that debt and were already servicing it; only its tax treatment changes.
Redraw vs offset: why the mechanism matters
An offset account holds your own money. Pulling money out of an offset to invest doesn't touch the loan balance at all, so it has no effect on deductibility either way. A redraw facility works differently: money sitting in a redraw is technically a reduction of the loan, and drawing it back out is treated as a new borrowing. That new borrowing takes on whatever tax character its use gives it. This is precisely why redraw, not offset, is the mechanism debt recycling relies on.
What TR 2000/2 actually requires
Taxation Ruling TR 2000/2 sets out how the ATO treats interest on funds drawn from line of credit and redraw facilities. Its core principle is straightforward: deductibility of interest on a redrawn amount depends on what that redrawn amount was used for, assessed separately from the original borrowing.
Where redrawn funds are used partly for investment and partly for private purposes, the loan becomes a mixed-purpose account, and interest must be apportioned on a fair and reasonable basis going forward. Critically, once an account is mixed, later repayments are applied proportionally across both the deductible and non-deductible portions, not selectively to one or the other. This apportionment requirement is the technical reason a clean loan split matters so much in practice.
If you pay redrawn debt-recycled funds back down and then draw them out again in stages, each repayment is treated as proportional to both the deductible and non-deductible components already in that account. Repeating this cycle steadily erodes the deductible portion, sometimes by tens of thousands of dollars in lost deductions over the life of the loan. The fix is structural: pay the split down once, in full, then draw it out (in one go or in stages) for investment, without repaying into it again.
Keeping the connection between borrowing and use intact
Beyond apportionment, the ATO also expects a clear, direct link between the borrowed funds and what they were used for. Funds that pass through a shared account, or that sit undrawn for an extended period before being invested, can weaken that link. This was the issue in the Domjan case, where routing borrowed funds through an account also used for personal transactions was found to break the connection needed to support the deduction.
In practice, this means using a dedicated loan split, drawing funds directly into an empty account used only for that investment, and investing promptly rather than letting the cash sit idle.
Joint loans and legally enforceable agreements
This is the area with the most risk of an unwelcome surprise, and it's where the ATO's own guidance on interest expenses is explicit. Where a property (or the resulting investment) is jointly owned, interest is generally deductible in proportion to legal ownership. Two joint owners who are equally liable for a loan each claim half the interest, by default, regardless of who actually made the repayments.
Where only one person owns the asset but the lender requires both people on the loan, the ATO's own published example addresses this directly: a sole owner can still claim 100% of the interest, but only where she and the co-borrower also enter into a separate legally enforceable written agreement, made at the time the loan is taken out, that sets out her sole liability for the debt and its interest. Bank statements showing that she alone made the repayments support that position; the written agreement is what establishes the intention behind it.
Recent ATO commentary has applied this same logic to debt-recycled loan splits where spouses are joint borrowers but only one intends to claim the deduction and own the resulting investment. Without a legally enforceable written agreement in place at the time the loan was obtained, the ATO's position is that each borrower is treated as incurring their proportionate share of the interest, which can mean only half the deduction is available even though only one spouse intended to invest and repay it. Given how much this can affect the outcome, this agreement should be arranged with a solicitor before the loan is drawn down, not after.
Getting the structure right from the start
Putting the pieces together, a properly structured debt recycling arrangement generally has each of the following in place before any money moves:
- A separate loan split for each debt-recycling tranche, distinct from the non-deductible home loan portion
- A redraw facility attached to that split, paid down in full before being drawn out, never left partially repaid
- Funds drawn directly into a clean account used only for that investment, with no mixing and no lingering delay before investing
- Investments that are genuinely income-producing, or held with a real expectation of producing income
- Where the loan is joint but only one person will own and claim the investment, a legally enforceable written agreement executed at the time the loan is taken out
- Records that tie each loan split to the specific investments it funded, particularly important if you plan to sell part of the portfolio later
Frequently asked questions
Not on its own. Debt recycling converts the tax treatment of debt you already have; your total borrowing and your total investment exposure stay the same. The separate decision to take money out of an offset to invest is what increases risk, since that step genuinely adds to the amount generating interest each month.
The account becomes a mixed-purpose loan under TR 2000/2, and interest must be apportioned between deductible and non-deductible use on a fair and reasonable basis going forward. Every subsequent repayment is applied proportionally across both portions rather than to either one specifically, which generally erodes the deductible share over time if you continue drawing and repaying without a clean split.
Yes, but only cleanly if a separate legally enforceable written agreement is in place at the time the loan is obtained, setting out that one party is solely liable for the repayments and interest on that split. Without it, the default position apportions the interest between both borrowers according to their legal interest in the loan, regardless of who actually repays it or who owns the investment.
This guide summarises general principles from Taxation Ruling TR 2000/2 and the ATO's published guidance on rental property interest expenses, alongside general commentary on debt recycling mechanics. It is general information only, does not take into account your personal circumstances, and is not tax, legal or financial advice. Debt recycling structures should be set up with a registered tax agent and, where a legally enforceable written agreement between borrowers is required, a solicitor, before any funds are drawn down.