TRADING PLACES- TO SELL OR NOT TO SELL?
If you’re planning to upgrade your current home, should you sell it or keep it as an investment property? This is the question most people ask themselves at least once during their lifetime.
Story STUART WEMYSS
The first home people purchase is generally not going to be their home for the rest of their lives. Firstly, it’s difficult for first homebuyers to purchase a large property that will service their future needs, especially in Australia’s capital cities.
Secondly, people’s preferences and requirements change, particularly when couples start a family.
Inevitably, the time comes when people are faced with the decision of whether to sell their existing property or retain it and rent it out as an investment property. In fact, the average family comes across this decision three or four times in their lifetime.
There are many issues to consider when making this decision. This article will discuss the main issues.
MOST IMPORTANT QUESTION
The first and most important question you need to ask yourself is, will your existing home make a good investment property? People are influenced by different things when they are choosing the location and type of their home. A home will not always make a good investment property. You need to consider two factors.
First, you need to consider the quantum of rental income and the likelihood of vacancy.
How much demand will there be for your property?
What percentage rental yield can you expect to achieve and how does that compare to the average for your area?
Secondly, you need to consider what capital growth the property might generate in the future.
These are the most important factors because there is no point hanging onto a property that is not going to perform well and might be vacant half the time.
A suitably experienced investment property advisor will be able to advise you if your existing property will be a good future investment.
They should be able to justify their opinions and recommendations with data and by citing fundamental factors as to why your property is or is not a good investment.
By fundamental factors, I mean things like proximity to schools, transport, new infrastructure, etc.
These are the things that will generate and sustain demand for your property which will ultimately push up the property’s value.
This could prove to be very valuable advice because retaining an underperforming investment can significantly retard a person’s wealth creation activities.
It’s called opportunity cost. That is, the cost of missing out on better investment opportunities.
When people purchase a home, a common strategy is to repay as much of their home loan as possible.
Of course this can be a good strategy, because a home loan is often a home owner’s largest expense.
However, from an investment planning perspective (ie. if your home turns into an investment property), it can come back to bite you.
A common misconception is that you can redraw or re- gear the home loan before you rent the property out.
For example, if you had a home loan for $250,000 and you repaid the loan down to $100,000, some people think that you can redraw the loan up to $250,000 and then claim the interest on the $250,000 as a tax deduction. This is incorrect.
Once you have repaid a loan, you cannot redraw the loan again from a tax perspective.
The Australian Tax Office treats every redraw as a separate loan.
Therefore, in determining if your loan will be deductible or not, you will have to look to the purpose of the redrawn funds.
For example, if you redrew the loan back up to $250,000 (ie. redraw $150,000) the ATO will look at what purposes the $150,000 funds were used for.
If they were used to contribute to the purchase of your next home (ie. a purpose that does not produce or has no nexus with taxable income), then the loan won’t be deductible.
You need to consider the tax effect if you have a relatively small loan.
Consider the example where your home loan is $100,000. Assume your home is worth $450,000 and you expect to receive $350 per week in rental income. That equates to $18,200 per year.
Interest costs will be approximately $7000 (at 7 per cent)and other costs might be approximately $5000.
Therefore, your property will produce a taxable gain of $6200 ($18,200 – $7000 – $5000 = $6200). Therefore, there are no negative-gearing tax benefits from this property.
I’m not suggesting that you should abort your plans to retain your property solely because it’s not tax effective. However, the tax effectiveness of your property is one element of many to consider.
One of the downsides to retaining your existing property and purchasing a new one is that you’ll have proportionally more non-deductible debt.
Continuing with the example above, assume that the person purchases a new home for $600,000 and retains their existing $450,000 property.
They will need to borrow approximately $640,000 to purchase this new property, including stamp duties and other costs.
They can borrow 100 per cent plus costs, because they can use their existing property as collateral security.
They will have $740,000 of lending secured by $1,050,000 of property (loan to value ratio of 70 per cent).
Therefore, they will have two loans:
1. Tax deductible investment loan for $100,000; and
2. Non-tax deductible home loan for $640,000.
It would be more tax effective if this situation were reversed (that is, if the tax deductible loan was higher than the non- deductible loan).
REBALANCING TAX DEDUCTIBLE DEBT
There are a few things you could do to rebalance your investment debt. One strategy is to sell your existing property to your partner or another entity such as an investment trust. For example, if your existing property was in the husband’s name only, you could sell it to your wife after you have purchased the new home.
Remember, you currently have two loans – one for $100,000 and one for $640,000.
Your wife could borrow 100 per cent of the investment property plus costs, say $475,000.
You would probably have to agree to repay the existing
$100,000 loan and some of the $640,000 home loan at the same time. Therefore, after repaying the $100,000 loan you would have $375,000 to repay off the home loan. Once this transaction has been completed your loan balances would be:
1. Tax deductible investment loan for $475,000; and
2. Non-tax deductible home loan for $265,000 ($640,000
– $375,000 = $265,000).
The total debt hasn’t changed (still at $740,000), but the split between tax deductible and non-deductible debt has been optimised.
This strategy would normally trigger stamp duty costs and may trigger other taxes/cost such as Capital Gains Tax (if you have previously used your home as an investment property), so you should run these plans past your accountant.
While upfront costs may be significant, normally the tax benefits arising from the high proportion of deductible debt will more than offset these costs within the short term.
As discussed above, if your property is owned jointly, then you could sell your existing property into a trust or other similar entity.
Of course, this whole process could well have been avoided if these people were advised to use the correct loan products from the start.
If you’re purchasing a property to occupy and then plan to move out of this property in the future and rent it out, you could consider using an ‘interest only offset account’. This is a type of mortgage product.
The benefit of using this product type is that any surplus income or extra repayments can accumulate in the offset account to save interest costs, since the offset account is linked to the loan account.
However, the main benefit is that these ‘extra repayments’ or ‘surplus cash’ are never paid into the loan account. Therefore, you’re never destroying the tax effectiveness of the loan amount.
For example, referring back to our first scenario where the person had a $250,000 loan, they would have been in the position where they would have had $150,000 deposited in the offset account and the outstanding loan still would have been $250,000.
When the time comes to purchase a new home you can just withdraw the surplus cash ($150,000) from the offset account. The loan balance of $250,000 would have been preserved.
SELLING GIVES YOU MORE DEPOSIT
Selling your existing home and therefore liquidating the asset into cash will give you a greater purchasing power.
The reason for this is because most lenders will only lend a certain percentage of a property’s value (normally less than 100 per cent).
Therefore, selling the property and using the cash will make your equity 100 per cent effective.
Perhaps the best way to explain this is to work through an example:
- Current property value $400,000
- Current loan $300,000
While you have $100,000 ($400,000 – $300,000) of equity you can’t borrow this much.
The maximum you can borrow (at 80 per cent, therefore without mortgage insurance) is $20,000 ($400,000 x 80 per cent – $300,000 = $20,000).
A $20,000 deposit is not going to help you buy much! However, if you sold the property, you should end up with approximately $88,000 in cash, after allowing for 3 per cent of selling costs. This is a healthier deposit.
Therefore, if you don’t have a lot of equity in your property and you don’t want to pay for mortgage insurance, then selling might be your only option.
THINK ABOUT YOUR OPTIONS
As the saying goes, hindsight is a wonderful thing. Forward planning is almost just as good.
Thinking about how long you’ll occupy your home and its future use can make a tremendous difference to the products and loan structure that you use. This loan structure can, in turn, have a huge effect on your tax position in the future.
If you take one thing away with you after reading this article, it should be to recognise the real value of forward planning coupled with professional loan structuring advice.
Sometimes simple and seemingly unimportant decisions can turn out to have more significant consequences in the future. Therefore, if you’re in doubt, seek advice.
Stuart Wemyss is a chartered accountant and the director of mortgage broking firm ProSolution.
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