With most of Australia’s lenders tweaking their investment lending policy and pricing in a bid to curb their level of investment growth, many potential investors are finding it harder than ever to obtain finance.
As a result, new data suggests there are now a growing number of potential investors choosing to turn their home into an investment property and buy another owner-occupied dwelling.
Provided it’s done correctly, turning a home into an investment property can be a very lucrative investment decision. With vacancy rates sitting at record lows, and many property markets showing strong annual capital growth, investment properties can be a real money earner for Australians.
Of course, before you pack up your belongings and look for alternative accommodation, it’s important to consider the various implications associated with turning your home into an investment property.
If you’re thinking of leaving your principal place of residence (PPOR) and returning to it sometime in the future, the six-year rule will allow you to rent out the property for up to six years, make claims for expenses and avoid capital gains tax once you sell the property.
If you rent the property out for longer than six years and then go to sell it, you’ll attract capital gains tax at the current discounted rate, on a pro rata basis for the amount of time the property was a rental.
The financial incentives
As with any investment property, the owner is entitled to certain tax deductions. Of course, if you’ve paid a significant amount off your owner-occupied property mortgage and then turn it into an investment dwelling, you may be negatively affecting your hip pocket. Say, for example, you had an $500,000 mortgage when you first bought the property and you have now paid it down and the current loan balance is $200,000. When you turn that property into an investment dwelling, that $200,000 you owe becomes your tax-deductible debt, not the $500,000.
When you first bought your owner-occupied property, your home loan was no doubt set up in order to cater to your needs at the time. Now that you’re thinking of turning that owner-occupied property into an investment, your mortgage may also have to change.
For example, if your loan is a line of credit, this will no longer be beneficial to you when you convert the owner-occupied property into an investment. The primary function of a line of credit is to offset any interest occurring on your personal owner-occupied debt, rather than your tax-deductible debt.
Similarly, if your current mortgage is a principal and interest loan, you may wish to convert it to an interest-only loan, especially if you’re going to take out a non-tax-deductible, owner-occupied loan on another property.
Gearing - positive or negative?
When a property is positively geared, you’re not making a loss on the property, as the annual rental income received from the property is higher than the annual loan repayments and holding costs.
Negative gearing on the other hand occurs when you do make a loss on the property. These losses can be claimed in your tax return, helping you to reduce your income and taking you to a lower tax bracket.
Working out which way your property will be geared is particularly important if you currently own the owner-occupied property with a partner or spouse. If the property has a negative cash flow, for example, it may be of benefit to have only one of the couple’s names appearing on the title – usually the higher income earner. This allows that person to make the tax claims and, since they’re paid more, get more tax back.
Owning an investment property brings with it many tax implications. As such, before you even think about converting your home into an investment property, it pays to do your research and speak with various finance professionals to make sure you’re making the right decision for your needs.
When calculating the net taxable income or loss from a rental property, it is easy to overlook the hidden and sometimes significant deductions available in depreciation.
The tax law states that a property owner can claim a deduction for the decline in value of furniture, plant, equipment and buildings that is used in or part of a rental property.
Take the time to learn what can and cannot be depreciated and you can avoid paying too much tax!
If you bought your residential property with a spouse or partner, you most likely put the loan under both of your names. This makes sense for a residence for many reasons, including making sure that your share automatically goes to your partner if anything happens to you.
Investment property is different. In order to minimise your tax burden, it is usually better to have the property under only one of the couple’s names. If your property is positively geared, it’s better that the property is in the name of the lower income earner – that way you are taxed less on the profits. If your property is negatively geared, it makes more sense to have the property in the name of the higher income earner. This will mean that they can make all of the tax claims and get more tax back (as they are likely paying a higher marginal rate).
If you keep your existing home under the same loan structure as you bought it with, you may lose out on these very useful deductions. The cost of this could be far greater than you think – up to tens of thousands of dollars.
Get the right loan
Many banks and lenders now offer investment property loans. These have different rates, criteria and benefits to residential loans. You can also choose to apply for an interest-only loan which means that you can pay any extra income into your new home, minimising the non-deductible interest you need to pay.
You should also investigate the possibility of refinancing your existing loan to make sure that you benefit from some of the structuring advantages and other things mentioned above.
With hundreds of different loans available on the market, it can be extremely challenging to search through all of the different options and find the loan that is best for you. Luckily, we are here to help.