Chapter 1
The purchase
Ian and Marie are long-time clients of mine. They operate an earthmoving business, and up until now have lived year to year on an income from which they have saved little. One night, Ian received a phone call from a canvasser selling negatively geared investment properties. He and Marie had paid off their house (with the assistance of a small lottery win) and were interested in the idea of investing, so he agreed to meet with the caller.
As it turned out, the promoter was selling residential units in Chermside (a suburb on Brisbaneâs northside). Chermside is well serviced by transport, schools and shops, and is reasonably close to the city. He appeared genuine and the coupleâs interest intensified.
That night, Ian and Marie made the decision to commence a journey into the investment world. Specifically, they decided to look into income-producing residential property.
I heard about it when they came in with their taxation records. They asked my advice, showed me the papers that they received from the investment company and told me they had signed a contract that was subject to finance. My clients knew little about investing, let alone investing in property. Further, they knew nothing about the effect of income tax on the investment. Nevertheless, they decided that they needed to provide for their retirement, and were disillusioned with the poor returns they had been achieving from their superannuation fund.
Income-producing residential property
Despite the lack of capital growth in recent years, I have long been a fan of income-producing residential property â on a long-term basis, that is. Real estate is an illiquid asset. As many have found, it can be hard to sell â particularly at a realistic price â if you need the money quickly. Gains are inconsistent. Prices may stagnate for years, then show a rapid appreciation in a short period of time before going into hibernation again. Despite this, property has a part in everyoneâs investment portfolio, along with shares, managed trusts and cash funds.
Ian and Marie listened intently as I explained the wisdom of a balanced investment portfolio that comprised assets from the various investment categories. But they, like many, did not have a lot of cash to invest and were borrowing to fund the purchase. They had been advised to negatively gear their purchase and, comfortable with that idea, they had decided to proceed.
Too many people base their decisions on tax savings rather than wealth creation. I have never understood why people would spend a dollar to save, at best, 46.5¢. If that spending does not provide a benefit other than reducing tax, why spend? In many instances the tax saving would only be 16.5¢, which means that a dollar has been spent to save 16.5¢. Some people spend a dollar that they otherwise would not, to save 16.5¢ in tax. Surely they would be better off keeping the dollar. I have lost count of the number of times I have heard that someone has advised the purchase of a new car to help reduce a tax problem. I canât understand why â spending to minimise tax just does not make sense.
My clients understood this; their decision was not tax-driven. They were interested in acquiring an asset to supplement their income upon retirement.
Negative gearing
Marie and Ian asked me to explain negative gearing to them. I told them that it is a simple concept where an investment returns a loss after interest is paid. Gearing relates to the amount of borrowing in an investment. Today, many rental properties are 100 per cent geared. None of the ownersâ cash is tied up. They are funded by making up for any valuation shortfall by giving a mortgage over the ownersâ residence.
In an economy where property values are rising, negative gearing results in incredibly high returns. Suppose a property is purchased for $110000 using only $10000 of the ownersâ capital. If the propertyâs value increases to $120000 in one year, a 100 per cent return of the investment has been achieved. Leverage is obtained by using someone elseâs money to make money for yourself. However, the higher the gearing the higher the risk and, as some have found, the higher the loss.
In whose name?
Ian and Marie had a joint taxable income of $80000. Divided equally, this resulted in tax payable of $9500 each (at 2007â08 income tax rates). Their marginal tax rate was 31.5 per cent including the Medicare levy. This means that for every extra dollar they earned they paid 31.5¢ in tax.
The contract they had signed was in joint names. I explained to them that property income is distributed in accordance with the ownership. That means that any profit or loss from the rental property would be shared equally.
They told me that a friend had told them that the property should be purchased by Ian. âFriendsâ cause a lot of trouble in this profession. Seldom is the advice they have so generously given correct. I have lost count of the hours wasted explaining that you canât claim for the raffle tickets purchased in the local art union; or you canât claim for driving your car to and from work every day; or that you canât claim for the cost of renovating a run-down property so that you can rent it out.
Seldom does the case arise where I can agree that a rental property should be purchased in one spouseâs name only â even if one of the partners is not working. For me, property investment is long-term: I believe in buying and holding forever so that one day the property will become income-positive. While in the first years there is the advantage of being able to offset a loss against the income of higher earning husband or wife, there is also the disadvantage of the loss eventually turning to profit and adding to his or her taxable income. Further, if a property is sold and a capital gain is made, that gain would be incurred solely by the person on the higher income. This course of action does not make sense. No-one has been able to give me a satisfactory solution to this problem. Some suggestions include, âBuy another propertyâ, but this would compound the problem. âSell half the property to the spouse, then.â What about the capital gain, legal fees and stamp duty payable? I remain to be convinced.
There has only been one clear instance in my years of practice when a property should have been, and was, purchased by the breadwinner. The client, who is a doctor and friend, was earning over $150000 per year. He wanted to buy a block of units and the tax savings far outweighed any later disadvantage, particularly given that he and his wife already owned other properties.
This issue wasnât a problem for Ian and Marie. They had decided themselves that joint ownership was for the better.
I have read an opinion that if property is bought short term with no borrowings, then ownership should be with the lowest income earner. Furthermore, if it is purchased long term with maximum borrowing it should be in the name of the highest income earner.
A calculation was provided showing the effect of the holding over five and ten years to support the argument.
If only it was that easy. In the first instance, property is a long-term investment, not short term, and even ten years is not long term in this context. Further, the assumption is made that the property will be negatively geared for the period of the ownership. I donât believe that is appropriate in a non-inflationary environment. The result would have been different if the calculations had been made over a longer period of time, and based on a principal and interest loan.
Interest-only loans
The unit salesperson had suggested Marie and Ian take out an interest-only loan to finance their investment. Again, I shook my head. This may be sound advice in a period of rapid inflation when property values are increasing, but not in an economy where inflation is low, such as in the 1990s and early to mid 2000s. Why rent a loss? This is what you are doing with interest-only money when values are showing little or no growth. The only time interest-only money should be used in a non-inflationary climate is when there are other loans on nonâincome-producing assets, such as your residence. In this case you are better off getting an interest-only loan for the rental property and using any surplus funds to repay the nonâtax-deductible loan off as quickly as possible. Once that is achieved, you should convert to a principal and interest loan.
You need to look at why you are investing. At some time you will want to be debt-free. Most of us will not want to be burdened with debt when we retire, so an appropriate strategy should be in place to prevent this â and an interest-only loan in a deflationary economy does not fit this description.
An opinion has been expressed that principal and interest loans have a disadvantage because, as the amount of interest decreases with the principal repayment, a loss of tax benefits results with the reduction in allowable deductions. You canât be worse off by earning an extra dollar. You can be by spending one. By reducing your interest debt you are increasing the net return from your rental property. The goal should be to reduce the costs, not increase them.
Interest-only loans are normally for a short fixed period. Every first-year accounting student is taught that borrowing short to finance long is to court financial disaster. Losses can occur when, at the time of refinancing, the lender is not prepared to carry on with the loan, and the property has to be sold in haste.
Construction cost write-off
The property at Chermside was six years old. This was an advantage in that a non-cash tax deduction exists for residential income properties on which construction commenced after 18 July 1985. People who purchase properties that were commenced between 18 July 1985 and 15 September 1987 are eligible for a 4 per cent allowance on the cost of construction. There is a 2.5 per cent discount for those who purchase properties commenced after this date. A 2.5 per cent annual claim is available for structural improvements commenced after 27 February 1992.
Once again, the purchase decision should not be made on the basis of the availability of this benefit. A property in a good area that shows consistent growth over a period of time may provide better gains than a property that qualifies for the write-off, but that is situated in a less affluent or profitable location.
Using a real estate agent
The person selling the property to Ian and Marie was not a real estate agent. He was a property marketer who sold negative-gearing schemes. As part of the lure to buy from him, he offered a guaranteed rental for two years. Ian is street-wise and passed that up. You can be sure that any guaranteed rentals will be above the market and will be paid for by the purchaser in the purchase price. He negotiated a lower price and decided to use an agent to find a tenant. The area in which my clients had purchased lets easily, but he felt the commissions an agent charges more than compensates for the hassles of finding a tenant, attending to minor maintenance problems and collecting the rent. My view regarding the engagement of real estate agents as property managers has done a complete shift from the view I had when I wrote earlier editions of this book. I have heard too many tales of poor management practice from clients, convincing me that it is something that should be done with great care, if at all.
Key points
- Income-producing residential properties have a place in every investment portfolio, along with shares, managed trusts and cash.
- The purchase should be investment-driven rather than tax-driven.
- Property is a long-term investment. With this in mind, seek advice from a tax professional as to how the ownership should be constructed.
- Give careful thought to your circumstances before accepting that an interest-only loan is right for you.
- A property in a good location without non-cash deductions may provide a better long-term gain than one with non-cash deductions in a less affluent or profitable location.
- The advantages of using a real estate agent to manage the property should outweigh the costs.
Chapter 2
The tax return
A year passed and Ian and Marie returned to my office with their annual income tax information, which for the first time included their rental property records. They opened the concertina file in which they had stored their records and proceeded to give me the details required.
The settlement statement
The first document they produced was the statement sent to them by their solicitor when the property was settled. I recorded the details, and placed them in a file marked âCapital gains informationâ. This would need to be kept for five years after the property was sold or, if a loss was incurred, until five years after it could be offset against an assessable capital gain.
The information I recorded included:
- the date of acquisition
- the cost of the property
- other costs of purchasing, including solicitorâs fees, search fees and stamp duty.
The loan documents
They then handed me...