The hidden tax cost of using property equity for personal spending

Releasing equity from an Australian investment property for personal spending is a common and legitimate financial decision.

In many cases, the property has increased in value, the loan balance has been reduced over time, and rental income comfortably services the debt. Using equity to fund holidays, upgrade a vehicle, or purchase a caravan can appear straightforward from a banking perspective.

While the decision itself may be simple, the tax consequences are often misunderstood.

The tax treatment is determined by what the borrowed funds are used for. The loan structure does not change that treatment. What the structure does is determine whether those different tax treatments remain clean, traceable and controllable over time.

A typical starting position

Consider the following scenario.

An investor owns a residential investment property valued at approximately $1.6 million. The outstanding loan balance has been reduced to $300,000. The property is fully rented and cashflow positive.

The lender offers an equity release facility of $200,000.

The intention is to use the funds for personal expenditure, such as holidays, a newer vehicle or a caravan. There is no immediate plan to acquire additional income-producing assets.

From a finance perspective, this appears uncomplicated. From a tax perspective, the way the loan is implemented now becomes significant.

How tax treatment is actually determined

Australian tax law determines interest deductibility by reference to the use of the borrowed funds, not by reference to the security provided.

Where borrowed funds are used to acquire or maintain an income-producing asset, the interest is generally deductible.

Where borrowed funds are used for private purposes, including holidays, vehicles or lifestyle spending, the interest on that portion of the loan is not deductible.

This remains the case even if:

• the loan is secured against an investment property
• the property remains rented
• the bank describes the borrowing as an equity release.

The next use of borrowed funds determines the tax outcome.

Loan structures matter

While the use of funds determines deductibility, loan structure determines whether different uses can be clearly isolated.

If personal expenditure is funded from the same loan account that originally funded the investment property, the loan becomes a mixed-purpose loan.

At that point, although the tax treatment of each dollar is still determined by use, the mechanics of the loan make that treatment harder to apply and harder to control.

What the loan represents after the equity release

Although the lender may present a single consolidated loan balance, the Australian Taxation Office views the loan by purpose.

In this example:

• $300,000 relates to the original investment property and remains deductible
• $200,000 relates to personal expenditure and is not deductible.

The total loan balance is $500,000, but the tax character of that loan is split internally by use, not by account.

The cost that is rarely quantified

At an interest rate of 5 percent, the annual interest on a $500,000 loan is $25,000.

Only the interest attributable to the $300,000 investment portion is deductible, being $15,000. The remaining $10,000 relates to private use and is not deductible.

At a marginal tax rate of 47 percent (including 2 per cent Medicare), this equates to approximately $4,700 per year in lost deductions. This outcome continues for as long as the private portion remains outstanding.

What happens once repayments begin

This is where structure becomes especially important.

When a loan is mixed, repayments must be apportioned across the loan based on the relative proportions of investment and private use. Borrowers cannot direct repayments to one component in preference to another.

In this example, 60 percent of the loan relates to investment use and 40 percent relates to private use.

A $2,000 repayment is therefore applied as:

• $1,200 reducing investment debt
• $800 reducing private debt.

This occurs automatically, regardless of intention.

As a result, the private portion does not extinguish independently. Deductible and non-deductible debt are reduced together.

Why this is difficult to correct later

As repayments are applied proportionally, the private component remains embedded in the loan unless it is repaid in full in a single transaction.

Making extra repayments does not isolate the private portion. Refinancing does not change the underlying purpose of the borrowing. The tax treatment follows the funds, not the lender or the loan number. This is why mixed loans often remain inefficient for many years.

Practical realities with lenders

In practice, some lenders require funds to be drawn down before a formal loan split can be created. In these cases, the equity is advanced first and the split is implemented immediately afterwards.

This procedural detail does not change the underlying principle.

Regardless of lender process, the objective should always be to separate borrowings by purpose as soon as possible, and ideally to design the structure before any funds are accessed.

Why multiple loan splits are often appropriate

Where there is any possibility that equity may later be used for income-producing purposes, multiple loan splits should be considered from the outset.

This allows:

• private expenditure to sit in a clearly non-deductible loan
• investment borrowing to remain fully deductible
• future investment funds to be clearly identifiable
• interest to be calculated without ongoing apportionment.

Effectively, this creates a clean and traceable line of credit for future investment while preserving the integrity of existing deductions.

The broader principle

The tax treatment of interest is determined by how borrowed funds are used.

Loan structure does not change that treatment, but it determines whether different treatments remain clean, manageable and defensible over time. The problem is not personal spending. The problem is allowing different purposes to be mixed without separation.

Final considerations

Before releasing equity from an investment property, it is essential to consider both the immediate and future intended use of funds and the structure through which those funds will flow.

Once borrowings for different purposes are mixed, the tax outcome becomes very mechanical and difficult to unwind. Proper structuring at the start helps preserve deductibility, maintains flexibility and avoids long-term inefficiency that cannot be easily corrected later.