Property Investment Insights ii

If you are borrowing to buy property, the rent will meet a significant portion of the interest payable on the loan, and the difference will be a loan, and the difference will be tax deductible. This is known as negative gearing. If you have a high income, then the tax deduction provides a valuable saving on your annual tax.

Like any investment, you want your property to be a good investment and go up in value. If you own a poorly performing property that has not gone up in value (and is unlikely to) and it is negatively geared, then your investment lacks integrity and is not realising your desired objective, which is for the property to increase in value so it will increase your wealth. In this case, the property should be sold.

In the examples above, if you buy a property worth $400 000 and rent it for $400 per week($ 20 800 per year) and your costs are $ 31 000 per year, then this property is negatively geared: negative because the cash flow is negative(it’s costing you $10 200 per year) , geared because you have borrowed money(geared the property).

Given the fact that the property is costing you $10 200 per year, it needs to be increasing in value to be a good investment. While the $10 200 is claimable as a tax deduction, if you are in the 32.5 per cent tax bracket, you receive a tax deduction of only $ 3 315 per year and the property will still cost you $ 6 685 per year ($ 129 per week).

However, people buy because it has increased in value by an average of 9.0 per cent per year for the past 20 years (according to research undertaken by Russell Investments, June 2012).If we apply that to the example above, the property of $ 400 00 is increasing in value by $ 34 000 per year and it’s costing you just $ 6 685 per year. You are therefore $ 27 315 better off. It is extremely difficult for most people to save this sort of money from their after-tax incomes when they take into account the cost of living in the 21st century, not to mention the discipline required to actually put money aside and not touch it – hence the popularity of negative gearing for many Australian to build their wealth.

Positive gearing is where you borrow money against a property, and the interest and other expenses are met by the rent. Simply, the positive portion of the expression means that the property is cash-flow positive: that means you are making money in a cash-flow sense. The gearing portion of the expression means that you are borrowing money. Simply, you borrow to buy an investment property and it earns you more than it costs you. Some commercial and many residential properties are positively geared. Often positively geared properties do not increase in value as much as negatively geared properties, but that generalisation may well related to city property versus country property. Of course, the ideal situation is to have a positively geared property that goes up in value. This hard to find but not impossible.

Mining towns with low availability of properties and a high demand of living quarters are a good example of such a situation, but prices have probably already moved, so be careful when doing your research.

For example, if a property purchased for $400 000 in a small mining town of Queensland or New South Wales is rented to miners at $750 per week the annual rent equates to $30 000 per year. Assuming the investor borrowed 100 per cent of the purchase price, the interest rate was 7 per cent, and expenses were $1000, giving a total expenses costs of $29 000, then the investor would still be ahead by $1000 per year. This is called positive gearing.

Further, because the property is positively geared, the investor will pay their highest marginal tax rate on the $1000.That is, 0 per cent if you earn less than $18 200; 19 per cent tax if you earn less than $37 000; 32.5 per cent tax if you earn less than $80 000, 37 per cent if you earn less than $ 180 000 and 45 per cent if you earn more than $180 000 per year.

For retirees or those on low tax rates, positively geared property make sense.

A loan-to-value ratio (LVR) is simply the total amount of money lent to buy or develop the property divided by the total value of the property (as assessed by the bank). For example, if you borrow $ 320 000 on a $400 000 property, then your LVR will be $320 000/$400 000 = 80 per cent. It is always a good idea to put a deposit for a property, so you have less to pay off over time.

You may hear bankers talking about lender’s mortgage insurance (LMI).

LMI is insurance that you pay for to protect the bank if you default on the loan. It is not insurance that covers you for not repaying the loan.

As the rule of thumb, a lender will require you to pay LMI when the loan-to-value ration of your purchase is greater than 80 per cent. For example, if you buy your first home or investment property and put down a deposit of just 10 per cent, then the bank will require you to pay lender’s mortgage insurance, which could be another$3500 on a $400 000 loan. It’s important to factor this into your research when you are looking for a property to purchase.

*Keep reading my article and insights and learn more about other types of insurances that might apply to your investment situation.

Generally speaking, for high-income earners it is often best to pay interest only on your investment properties to free up your cash flow to buy more property, which maximises in value – assuming it does go up in value.

If you are on a lower income, interest only also works well to free up your cash flow to cover the costs of living.

But if you can afford to, it’s always best to repay the loan , too, because when it comes to the retirement you don’t have to meet the cost of the loan, which means that you do not have to sell the property and you can leave off the rent. So principal and interest makes sense if you can afford it, but always try to pay down the loan on your principal place of residence first to eliminate your non-tax-deductible debt.

Vacancy rates are the percentages of rental properties that are available for rent but without tenants. If you are looking at purchasing an investment property it is always helpful to know the vacancy rates in a state and in a specific area to assess the potential for you to find a tenant for your property.

The mainstream investment property magazines print the latest data for vacancy rates on the back pages of their magazines. The Property Council of Australia or your state Real Estate Institute (for example, REINNSW, REIQ) also offer reports for you to purchase, but you may have to join as a member to obtain the reports.

If vacancy rates are high, then you will have less chance of finding a quality tenant, and there will be little pressure on rental income to improve, as demand will be low. If vacancy rates are low, as they are at present owing to a housing shortage, then rental income is likely to rise steadily and finding quality tenants should not be a problem.

Three to 4 percent is considered a low vacancy rate and post-GFC rates in Sydney and Brisbane, for example, were well below that level, indicating upward pressure on rental yield, which is positive for investors.

One of the best things about property is that you can renovate the property and increase its value. If you do the work yourself, and do a good job, then you can save on the improvement cost and profit when you sell it or rent it for more than it was worth when you first bought it.

If this your plan when you buy an investment property, it’s very important that you cost the renovations realistically. Renovations can be a disaster if you attempt them without the requisite skills and finding a buyer for a property that has been ruined by an inexperienced renovator may be difficult.

It’s recommended to have renovations done by professionals to increase the chance of selling the property at premium price.

The final thing you will want to know about property investment is capital gains tax (CGT). This is not a separate tax; it is part of your normal income tax. So, if you make a gain in a particular financial year, the taxable gain is added to your taxable income in the financial year.

CGT applies to all assets purchased after 21 September 1985 and subsequently sold. You have to realise the gain to pay CGT, which means you have to sell or transfer the asset to another name. Both activities are triggers or C.G.I. you don’t sell (or transfer) an asset, you do not pay capital gains tax.

If an asset has been owned for more than 12 months then a 50 per cent CGT discount applies to the sale if the asset was in an individual name, as tenants in common, as joint tenants or in a trust (super funds receive a 33 per cent discount).The discount done not apply to assets held in a company name and companies therefore pay CGT at the company tax rate(currently 30 per cent).There is also an outdated indexing method that helps reduce CGT, but I have never seen it outpace the 50 per cent discount method.

Here is an example of how CGT works. An investor purchases a property in April 1992 for $ 200 000.The property is sold in 2011 for $600 000 and is subject to CGT. The calculation is show in table 5.6.

If the asset is owned by just one person, then $200 000 is added to their taxable income in the financial year that contracts are exchanged on the property, and the normal tax rates apply. For example, for the property shown in the table 5.6, if this person was earning $60 000 per year then the $200 000 taxable gain is added to their taxable income for the financial year. In the 2014 financial year, their tax would be $ 90 546(excluding Medicare levy) and they would take home $ 569 454 excluding the real estate agency and legal costs, as shown in table 5.7.

If the property is owned in joint names or as tenants in common then the taxable gain amount would be split between the owners, depending on what percentage of the property they own. If a property is owned by a couple as joint tenants, then the taxable gain is slip 50/50 between the two ownership this example, the taxable gain of $200 000 is slip 50/50 between the two owners, so $ 100 000 is added to each owner’s taxable income for that financial year.

Based on the distribution of capital gains tax, timing of the property sale is very important. It is always best to sell a property when your taxable income is at its lowest. That may occur after retirement or in a year that you are not working for some reason.

Another way to reduce your taxable income is to make sure that, in the year in which you are selling your property, you maximise your concessional superannuation contribution (15 per cent tax is applied and the amount you can contribute is limited to $25 000 per year).

This can be done through salary sacrifice arrangements at work or if you are self-employed by simple making the contributions to your super fund.

For Your Information

Make sure you seek advice if you planning to sell a property , or take a look at the video www.samhenderson.com.au on how to reduce your CGT.

CGT does not apply to assets inside superannuation for superannuants who are in account-based pension mode – that is, drawing money from their super. If you buy a property inside, you’re your self-managed super fund and sell it after you retire, then you will not pay CGT. Always give consideration to the name in which you buy your investments.

Capital Gains Tax (CGT) and your principal residence

Your principal is free from capital gains tax. Under tax law you are allowed one principal residence; any other residence, such as an investment property or holiday house, will be subject to CGT when you sell it.

If you rent your house for a period of time, then the calculation for capital gains is pro-rata for the number of days it was an investment property. So, too, if you move into an investment property for a period of time and becomes your principal residence, then the time spent in the house or unit will be deemed to be CGT-free on a pro-rata basis.

It is always recommended that if you live partially in one property you should obtain a valuation from a licensed professional valuer , not a real estate agent, to ascertain the value at the time you moved in or moved out to assist with calculating your cost base for capital gains tax purposes.

Your cost base is the value of the property plus the cost of any capital improvements you have made to the property. For example, if you paid $ 300 000 for a property and spent $50 000 on a renovation, then your cost base will be $350 000.Anything you make on the sale of the property above the $350 000 will attract CGT.

I have had many clients say that a friend told them that they could live in a house for period of six to 12 months and it would not be subject to capital gains tax. No such law exists. However, there is a law (‘ the six-year rule’ – section 118-145 of ITAA 97) that allows you to move out of your principal residence for up to six years and rent it out. If the house is sold, it will remain free of CGT within the six-year period. This Australian law is designed for people who move overseas or interstate because of work and have to rent, or even buy somewhere else. If you buy somewhere else, only one house can be your principal residence and free of CGT.

The real secret to property investment – any investment for that matter – is to consider the factors affecting your return on equity. Your return on equity is your actual return on the money that you put into the investment. Here is a simple example. I put a deposit down on my first property in 2002 of $15 000 and spent $ 30 000 renovating the property over five years. The property value increased from $155 000 to $ 360 000 over that period and sold the property in the late 2000s.

The total amount of equity I put into the property was $45 000($15 000 deposit and $ 30 000 in renovations) but I sold the property for a profit of $175 000($360 000-$155 000-$30 000 in renovations and other costs).The return on my equity was $175 000/$45 000=388 per cent over five years or an average of 77.6 per cent per year on my equity, representing my internal rate of return. That was a good investment.

A more complicated and up-to-date example could look like this: I buy a two-bedroom apartment by the beach near Sydney today for $700 000, put down a 10 percent deposit and rent it for $ 700 per week. I expect a property price to growth of 8.5 per cent per year. With a loan of $630 000 at 7 per cent interest and stamp duty and legal costs of $30 000, my equity would be $100 000($70 000 deposit plus $30 000 in costs).Interest on $ 630 000 at 7 percent would be $ 44 100 per year plus strata fees, rates and costs of around $ 3000 per year, so the unit would cost me $ 47 100 per year to maintain.

Rent would be $700 per week and assuming a 52-week rental cycle and full occupation for the period, which is ambitious, I can expect a total annual rental return of $36 400 per year. If the property increases in value by 8.5 per cent per year then it is increasing by $59 500 in the first year and then the increase is compounded thereafter. So my total return in the first year will be $ 36 400+$59 500= $ 95 900.

If I deduct my annual costs from this figure arrive at a net increase of $48 800($95 900-$47 100) in the first year. Think how long it would take you to save that sort of money each – that’s almost $1000 per week.

My return on equity would be $ 48 800/$100 000 = 48.7 per cent.

This is good result, but remember property never increases consistently at 8.5 per cent per year, or any other percentage level. It rises and falls in bursts and the key to a successful experience is time and sitting through the various cycles.

Not only would I have a high return on equity, but I would also be able to claim a tax deduction for the difference between the rent and the annual costs. So, I must be able to afford to pay the difference, which, in cash-flow terms, would equate to $10 700 per year. This cash-flow loss is 100 per cent tax deductible. That is, 100 per cent of the        $10 700 is used to reduce my taxable income for the financial year.

Property is a good tool for building wealth because you can effectively borrow someone else’s money (the banks) to buy the property and then have someone else (the tenant) Pay it off for you. This only makes sense when you have a reasonable income to meet the difference between expenses and the rental income. So, retirement or the years just before retirement Are not necessarily the best time to gear into property investment through super, because you need a free cash flow to pay a pension in retirement unless you can repay the debt.

The best friend of a property investor is time: when people retire, they need an income to support your lifestyle, and they no longer have time to let the property increase in value and pay down the debt. When you take into account property rental yields, Council rates, water rates, maintenance, agents’ management fees in all the other costs of maintaining the property, often it makes little sense to own an investment property in retirement. Add the burden of interest on an investment property loan, and the equation rarely makes Sense unless you have a positive cash flow property, or have you nearly paid off the property.

Shares and cash or fixed interest often make a better investment for retirees. Because the yield is higher after expenses (there are a few expenses with share ownership, and dividends can offer tax refunds, increasing the income yield) and you can specifically pick stocks that have high tax-effective income.

With that being said I have some clients with good commercial properties that have been paid of producing excellent income for retirement. Commercial properties typically return 6% to 10% per year the key here is to do your homework and stay focused not on the actual investment but your life goals and financial objective. If you need a certain income from investments, then it may make sense to sell a property and put the money into superannuation where it will be tax-free in retirement and produce a good income to sustain your lifestyle. Thus, property works well for creating wealth and shares and their low ongoing costs and good income work well for wealth management.

In Australia there is no shortage of people who are only too willing to sell you property, finance or any other services associated with property investment , so you need to decide what you want before you embark on your project .You will also need to be well researched so can identify value , potential and opportunity when you see it.

There are so many options in property that it can be overwhelming; devising a process methodology will overcome many of the pitfalls associated with buying. The following 10-steps process will provide such a methodology for your ad serve to incorporate all of your objectives, requirements, restrictions, costs, research and options so you can make an informed decision.

The following 10 steps are a sure-fire way to better property investment:

1. List your objective and goals
2. Compile a list of costs
3. Set your budget and what you can afford
4. Obtain finance
5. Undertake extensive research for the desired areas within your budget
6. Start looking for the right property
7. Research and run a project assessment sheet
8. Negotiate on the property
9. Time to buy
10. Settlement and project commencement

Five Sample Strategies

1. Start planning and/or saving now to achieve a deposit + stamp duty + legal fees
2. Research areas to buy property
3. Obtain a depreciation schedule for investment properties
4. Calculate your after-tax cash flow as part of your planning to buy a property
5. Obtain/secure finance before you start looking for a property