Do
sums on second house
At
last you have found your family-sized dream home and are ready to
move from your cute little cottage. But you face a dilemma: do you
sell the cottage to reduce the mortgage on your new home, or keep
it and rent it as an investment?
For many people the answer is clear-cut: they can't afford the new
house unless they sell the old house. However, a growing number of
high-income earners are finding that by the time they are ready to
move to a family home, they have paid off their existing mortgage
and can afford to keep both houses.
The usual back-of-the-envelope calculations go something like this:
Reborrow the full value of the cottage, secured against the cottage,
apply these funds to the new home, rent out the cottage and claim
the interest repayments on its mortgage as a tax deduction.
Voila! Non-deductible interest on a family home loan is effectively
converted into deductible interest on a residential property investment.
Not so fast.
The national director of Taxpayers Australia, Peter McDonald, says
there is a huge problem with the scenario described above. "If you've
paid off your first house so that you own it outright, you can't negatively
gear it," Mr McDonald says. "It is what you are using the borrowed
funds for (buying your new family home) that determines whether the
interest is tax deductible or not. What you are using as security
for the loan (the cottage) is irrelevant. You may think you've negatively
geared it but the short answer is you haven't. All you've done is
used your existing collateral to get a further home loan for your
new residence. You're not going to get any deductions for that."
If you have not fully paid off the loan on the cottage, interest repayments
on the outstanding balance are tax deductible if the cottage is rented
out. For many people, this is not sufficient to make the strategy
worthwhile. And there is another catch. Mr McDonald warns that if
you have used a mortgage offset account on your cottage loan, the
tax deductible outstanding balance may be less than you think.
"Once you've applied your spare funds to the outstanding mortgage,
when you start to withdraw that back out again for other purposes,
you don't reinstate the loan," he says. For example, the original
loan may be for $150 000 and you pay off $50 000, reduce it to $100
000 then redraw $20 000 for renovations. The outstanding balance on
the loan is $120 000 but for tax purposes you can only deduct the
interest payable on $100 000. Mr McDonald says the only way to really
make the strategy work is to sell the cottage to a family company
or trust.
"That way you could take all of your equity out of the property, negatively
gear it to the hilt, then apply what was your equity in the first
house to the second house and effectively turn the original house
into a negatively geared investment."
Again, however there are a couple of catches. One is that the family
company or trust would have to pay stamp duty on the purchase.
A second issue is capital gains tax if you eventually sell the cottage.
If you held on to the cottage as an individual, the sale would be
capital gains tax free for the proportion of time that it was your
primary place of residence.
You would only pay capital gains tax at 50% of your marginal rate
for the proportion of time that you rented it out as an investment
property. If you instead sold the cottage to a family company or trust,
you would retain the capital gains tax exemption on the period of
time that it was your place of residence, but the company would pay
full capital gains tax for its period of ownership (and the same rules
apply for trusts from 2001).
"You have to work out what your greatest advantage is going to be,"
Mr McDonald says. Is it going to be through the capital growth? Then
devise your strategy accordingly." Tax considerations aside, Mr McDonald
says it might be that the cottage is such a fantastic investment and
its prospects for capital appreciation are so great, that you decide
to keep it. Even though you may miss out on tax deductions for interest,
or they may be severely reduced, you may in fact be better off holding
on to the cottage," he says. "The investment potential may far outweigh
the tax considerations."
Dominic McCormick, research manager at Bridges Financial Planning,
agrees that if the cottage is such a great investment, you might want
to keep it. But as a general rule, he says most people would be better
off selling up.
"It is probably a better strategy to sell the previous house capital
gains tax-free and use that as a deposit on the new house, then maybe
draw down a loan on that and perhaps invest in shares," he says.
Mr McCormick also points out that keeping two properties is like putting
all your eggs in one basket. "The problem is, if you've got one property
and you buy another, you've got total exposure to property and really
no other assets," he says.
Another issue is maintenance.
Many people sell their first home after five to seven years and it
might need paint, a new hot-water service, or the roof needs repairing.
These are expensive procedures that a tenant will demand and paying
for them will eat into the cash available for reducing the mortgage
on you new home.
The final thing to consider is cash flow. Mr McDonald and Mr McCormick
warn that a strategy that requires two loans and two homes to be maintained
requires a fair amount of spare cash. |
