DEBT RECYCLING INVOLVES converting bad debt into good debt. In other words, converting debt you cannot claim as a tax deduction into debt that you can.
This can be a little complicated to explain so take a look at a couple of practical examples.
Debt Recycling Example 1
You have a factory you conduct a business from with a value of $500,000 with no debt attached to it. You also have a mortgage on your own home totalling $500,000.
One important point to consider is that you cannot structure things purely to gain a tax benefit (and I’ll talk more about this in a moment). But there must always be some other benefit involved, no matter how minor.
The answer here in the example is to re-structure for retirement planning and asset protection — by selling the factory into your own self-managed superannuation fund (SMSF) to repay the home debt.
You can have the SMSF borrow and utilise an instalment warrant to fund the purchase in a much more tax effective (friendly!) way.
Selling the factory may attract capital gains tax, however most small and medium businesses will qualify for the CGT rollover reliefs. And can pay no tax when it is done correctly.
You can read more about the CGT rollover concession here.
Debt Recycling Example 2
Let us work through another example:
You have a $500,000 loan at 5% that costs $25,000 per annum of non-tax deductible interest means you must earn $38,000* in pre-tax dollars to cover the interest. A more tax effective structure is to recycle the debt and offset it against post-tax dollars.
*In this example, we are using a tax rate of approx. 34%. For a taxpayer in the top tax bracket for 2013 — you would have to earn around $46,000 to pay the $25,000 in non-deductible interest after tax.
This means BIG tax savings for you and they compound upon each other every single year!
What Does This Mean For You?
Without going into great depth … there are many other tax savings available to you when you recycle your debts.
If you use your SMSF to rent your own business to yourself, you are taxed at a much lower rate than the tax deduction you are claiming (even zero tax rates in retirement phase).
Future capital gains are then taxed at a much lower rates or maybe not at all — if they are structured right.
BOTTOM LINE: This is a relatively straightforward for a professional advisor dealing in tax and superannuation. But it is full of traps, so seek professional advice!
Also remember the earlier word of warning — you cannot enter into a scheme solely for the purpose of obtaining a tax benefit*. However, restructuring your affairs as part of normal practice is perfectly acceptable.
Once again, visit an advisor to ensure you are not breaking any tax laws.
* To learn more read Part IVA of the Income Tax Act, which is the general anti-avoidance rule when it comes to income tax.