Financial planners divide debt into two types: deductible debt and non-deductible debt.
Deductible debt lets the borrower claim a tax deduction for the interest incurred on the debt. Non-deductible debt does not. Whether interest is deductible or not can have a massive impact on how expensive that debt actually is.
When interest is not deductible, you have to pay tax before you pay the interest. You can see this with an example: If your nominal interest rate is 5%, and you are a 45% taxpayer (the highest tax bracket), the effective interest rate around 9% before tax. To understand this, consider an interest bill of $5000. A person paying tax at 45% has to earn $9000 in order to pay this bill. Of this $9000, they pay $4050 in tax to the tax office, leaving (virtually) $5000 remaining to pay the interest.
When interest is deductible, you don’t have to pay tax before you pay the interest. So you only have to earn $5000 to pay an interest bill of $5000. Here is the effective rate of interest on non-deductible debt for different levels of income:
|Income||Marginal tax rate||Effective interest rate on a non-deductible 5% loan|
The effective interest rate can also be thought of as the ‘pre-tax’ interest rate. As the table shows, when debt is non-deductible, the effective interest rate is much higher than the advertised, ‘nominal’ interest rate.
So, what makes debt deductible?
Interest is usually deductible where debt is used to pursue or generate taxable income. A simple example is where people borrow to buy an investment property. Provided that that investment property generates taxable income for the investor (that is, the tenant pays rent), interest on that loan will typically be deductible for the investor.
Remember, the rent received in such an example is also taxable as income. But if the interest payable is more than the rent received, then the net effect for the investor/borrower is that their tax deduction is more than their increased tax liability. We call this negative gearing.
Investment loans are probably the most common example of deductible debt. Another common example is where borrowers use debt to finance a business activity.
Whether or not interest is deductible can be quite a technical decision. Therefore, you should talk to your advisor before assuming that interest on one or more of your loans will be deductible.
The tax advice component of this article was produced by Rolando Chou, a registered tax (financial) adviser.