Sprocket,
to be tax deductible you have to borrow money for an investment purpose.

But you cannot redraw and put it in an offset account and get a deduction.
however you could get a
line of credit on house one living in it as your PPOR and using the line of credit loan against it as a deposit for an additional investment property. This would separate the loan so it is easy to see what has been used for an investment purpose.

see
http://law.ato.gov.au/atolaw/view.htm?Docid=TXR/TR20002/NAT/ATO/00001&PiT=99991231235958
or
https://www.propertyinvesting.com/forums/getting-technical/finance/4327592?highlight=redraw

When you ask about tax deduction on interest you have to look at your marginal tax rate that you are on with your job wage.
If you are on 30 cent in the dollar you have to spend one dollar in expenses to get back 30 cents.
If you save having to pay the dollar you may have to pay 30 cents in tax if it causes a profit compared to spending one dollar to get 30 cents back (70 cents loss)
go to http://www.ato.gov.au and do a search on tax rates

Now if you own (rather than bank)  almost 100% of house one and rent it out you may pay 30c in the dollar on the rent is this such a bad thing.
You may be able to use this extra income to pay off the second house.

coretex
Use an offset account it does the same thing as paying more equity without the hassle in the future of redraw not being claimable.  You can use the offset balance for whatever you want without having to explain why you used it.
If you use an offset account it will reduce the interest charged on your PPOR loan and in six months time you can decide if you want to use the cash balance or reduce your interest bill.

Option 3 – Ask yourself where is PPOR exemption going to be on the country house or remain for 6 years on the city house.
If you move the PPOR to country house you need to get a valuation done on the City house as it is no longer PPOR and you need to establish cost base for future Capital Gains Tax event ie selling .

If you are planning on getting the first home owners grant then you will have to live in the house to begin with.
Always look at the long term outlook .
If it is a liability for 12 months but is turned into an investment after 12 months for say 15 years with a consistent plan to pay it off .
Then the small liability time of 1/15 of the time may be worth it to get your foot into the property market as long as your employment is stable.
You may have trouble getting a loan if a consistent savings plan cannot be shown and a period of time employed. (permanent status)

Another thing to be aware of is that if you get a trade person to do work on your property and they are somehow injured you could be legally liable if the accident happened on your property in Australia.

If you are able to live with your parents you could pay off the loan big time by renting the whole house out and using the rent and your income to pay off the loan.
 It seems like you are getting no where but the $270,000 loan at 20 years at 7% costs $202,000 in interest where as from the loan going down to $240,000 at the same repayment level of $965 a fortnight costs $154,000 in interest over 20 years at 7% p/a.
Each time you make an extra repayment you are biting into the principal amount and you will get to a point where the interest cost becomes less than the repayment amount and the repayment of the loan accelerates.
You might wish to get the loan amount to a point where the interest amount equals the rental income minus expenses
When you get to this point you have a property that costs you nothing to hold if you are renting it out.

Also you noticed the property value increased in two years.
if you worked it out it would be about 7% a year compounding

so based on a figure of a 7% p /a average compounding rate  your property could be worth
$531,000 in ten years time
and
$370,000 in 5 years time.
Your loan would be $185,000 in 5 years time . So your net worth would be $370,000 – $185,000 = $185,000
Your loan would be $100,000 in 10 years time . So your net worth would be $531,000 – $100,000 = $431,000
based on a repayment of $965 a fortnight without any extra repayments at 7%
Your loan in twenty years time would be zero and the value of the house might be $1,000,000

What I am trying to highlight is how money is made over time with a consistent investment savings plan.
It is hard at twenty to see ten years down the path.

If you sell the house you miss out on any future capital growth.

On way of increasing the value is through improvement on the property.

the reason that banks look at less rental income is to factor in vacancy periods if you lose a tenant.

Maximum Leverage and positive cash flow don' t  always go together. If you get the principal down you increase your borrowing power and reduce risk.

"I still don't see how it's possible – with our banks' lending criteria – to build a substantial property portfolio of (+) cashflow properties if the investor has relatively little capital to spare and a limited salary."
It is hard to begin investing but as you pay off the loan and the value goes up it will get easier and also accelerate if you keep feeding money into the investment.

I am willing to put heaps of effort and study into ways of FINDING good deals (positive cashflow properties – but the other half of the equation seems to be missing … the half that both Robert Kiyosaki
Robert also stated Cash is King when this economic cycle occurs as money is hard to borrow and someone with cash can snap up bargains.

You might find this book interesting to read
Unlimited CashFlow – It’s easy make money in Property
http://www.propertyupdate.com.au/pages/Craig-Turnbull-Books.html

What about a family member guarantee on the amount that is the short fall to keep lender happy.

Maybe a joint partner like girl friend if she has a job

I had the same problem when I went to university and still have the problem due to not getting a job after university so I have limited borrowing power.

It has been hard for me as I haven't had a job for 7 years after going back to university after leaving a nice secure job. I have this bug you are mentioning but not having income has put me in a holding position at the moment. When I get a job again it will be full steam ahead but when that is I don't know. I have been a house dad to two daughters while my wife supports me and that has been price less and next year my daughters both be starting school so I should be able to devote time to either getting a job or running my part time business full time and property investing.

Its hard to predict where the bottom or top is,
 I had in my opinion a bottom level close to 3200 on the all ordinaries index.
My opinion is based on the long term average bottom support level of the all ordinaries over the last 10 years ignoring the crazy upwards surge that happened before the collapse.
However some of my shares are climbing back up although I am still in a loss situation with these shares.

Dolphn Girl,
Depends on what the purpose of the other debts are for.  Investment debts or Private use debt.
(there has to be a direct nexus between the loan and the income producing purpose- tax law wording in ITAA1936)

Nexus means connection or tie 
Section 8-1 Tax assessment Act 1997
http://law.ato.gov.au/atolaw/view.htm?locid=%27PAC/19970038/8-1%27#8-1
Investment debts or Private use debt.

If the other debts are private use then your consolidated loan is not going to be 100% investment related.
And will be difficult to determine how much of the interest is for investment and how much is for private at future tax time when you decide to rent it out.
If the other debt is private use a seperate line of credit loan would isolate the private use debt from the investment debt
just do not mix private use with investment use.
Some banks allow multiple line of credit loans secured against the house so you can have a line of credit set up for personal use that is non tax deductible and then have another line of credit loan for some kind of investment purpose if the need arose.
My bank allows 5 line of credit accounts
At the variable house interest rate.