About Stuart WemyssMost investment properties are cash flow negative for the first few years of ownership. That is, the rental income received is not enough to cover all of the property’s expenses (especially interest which is the largest expense).
This turns some people off investing in property, because they do not necessarily want to commit to meeting a cash flow deficit every month from other income. Well, you don’t have to. There is a solution that is worth considering.
I will show you how to structure your loans so that the investment property ends up paying for itself.
You don’t have to use any other income to support the property. Best of all, you could use almost any lender to do this. It does not require any “special” or expensive loan products. The skill is in the structuring.
What’s wrong with negative cash flow?
Some people choose not to invest in property, solely because of the need to commit to meeting a negative cash flow each month. There can be a number of reasons for this. For example, they might be in a high expense stage of life (e.g. paying for private school fees), or they might feel more comfortable if they are channelling all their spare cash flow into their home loan to eliminate it before commencing with any investing.
Eliminating the negative cash flow – the loan structure
The negative cash flow that a property produced is eliminated by establishing a line of credit. This line of credit is used to pay the interest on the investment loan (used to purchase the property) and property expenses. This frees up the rental income to be used for any other purpose such as repaying non-deductible debt.
Is the deduction allowable?
Many people know about the Harts Case that went all the way to the High Court of Australia. The ATO denied a deduction for interest (which the Harts claimed). The Harts established a loan structure which included a split loan with one split being used as a home loan and the other an investment loan. No repayments were made on the investment loan, so the interest was added to the balance.
Each year, the balance would increase and so would the interest deduction claimed. There were two critical considerations the High Court took into account when they decided to support the ATO in denying the deduction. Firstly, the mortgage product advertising materials heavily promoted the product based on the potential tax savings it could deliver. Secondly, the Hart’s used a split loan rather than two separate loans.
The ATO issued Private Binding Ruling 69725 which applies to the financial year ending 30 June 2007. An edited copy of the ruling can be found on the ATO’s website here. The ruling assessed a situation where the person had a home loan and a totally separate line of credit. The line of credit was used to invest in managed funds.
The ATO lists a number of specific product features of the line of credit (this is important). The borrower chose to make no repayments on the line of credit and allowed the interest to accumulate (capitalise) in the loan.
The ATO determined that the interest on the line of credit was fully deductible as they concluded that it did not conclude it contravened any anti-avoidance tax provisions, as the borrower did not enter into the loan structure with the dominant purpose of obtaining a tax benefit. The borrower simply did not wish to use personal funds to repay the interest on the line of credit.
Once again, I stress that there were certain considerations about the loan structure and product features which assisted them in reaching their conclusion. Therefore, before implementing a similar structure for yourself, you must get advice from a suitable trained professional (i.e. ProSolution!) to ensure you have the correct product and structure.
Optimise the structure
This loan structure sounds like it might be a good idea for some people, but is it important to look closely at the numbers. . I assess the following situation.
Home loan $350,000
Line of credit $475,000
Annual salary $150,000 p.a. gross
Rental income $310 per week
Dependants Wife and two children
Living expenses $3,100 per month
I assessed two scenarios:
1. The borrower made interest only repayments on the line of credit and used all his remaining surplus cash to repay the home loan. This would be the most common arrangement.
2. The borrowers used all after tax income (rental and salary) to repay his home loan. The borrower made no repayments into the line of credit. In fact, he used the line of credit to pay for the investment property expenses as well. Once the home loan is repaid in full, he starts to make repayments on the line of credit.
Scenario two was the winner and resulted in the borrower paying $65,882 less in interest. In scenario two, the borrower repaid his home loan in 52 months (4 years and 4 months) and then repaid his line of credit in 8 years and 6 months. Therefore, both loans were fully repaid in less than 13 years with a total interest cost of $493,000.
In scenario one, it took the borrower 8 years to repay the home loan and then a little over 7 years to repay the investment loan. All up, it took this borrower 15 years and 3 months to repay both loans with a total interest cost of $559,000. Therefore, the borrower in scenario two saved $66,000 in interest and repaid both loans 2 years and 2 months quicker than in scenario one.
Equity = opportunity
Obviously, to initiate this strategy, you must have sufficient equity in your existing property/s. Equity is a tremendous asset because it gives you the opportunity to invest without you needing to contribute any cash.
Some people could be sitting on a mountain of “opportunity” and not even know it. Putting it another way, some people could be wasting a great opportunity (i.e. those that have plenty of equity) to create tremendous wealth just because they don’t know how to do it (or it will cost them money).
But you may never end up using this structure
You may regard this loan structure as a safety net only. Your major concern with purchasing an investment property might be needing to reduce the amount of cash you spend elsewhere (e.g. schooling, holidays, etc), in order to support the negative cash flow the property generates. You may not want to be put in that position, so you opt not to invest. This loan structure provides you with choices. This structure means you may never have to adjust your current standard of living, because the loan will finance the negative cash flow. That said, curbing discretionary expenditure so you can contribute to investments is always a good idea!
Asset selection is so critical
I cannot stress enough how important asset selection is. You need to be investing in the highest quality assets so that you can maximise the chances of enjoying strong capital growth.
Asset selection is even more critical when you are using a loan to fund the negative cash flow, because you want the property’s value to increase significantly more than your outstanding loan balance increases, to make it worthwhile. In my calculations, I have used an average capital growth rate of 8%.
Anyone that invests in property should be aiming to achieve a growth rate of at least 8%. A 1% reduction in capital growth (i.e. down to 7%) results in a reduction in property value by $316,000 by year 20. However, an increase in capital growth rate by 1% (to 9%) results in an increase in the property’s value by $378,000 by year 20.
Therefore, in my opinion, you really should seek professional advice (or at least a second opinion) from a professional investment property advisor, before making an acquisition. With so much potential wealth on the line, you would be silly not to.
Risks – never borrow more than you can afford!
I want to be absolutely crystal clear! I am not suggesting that you borrow more than you can afford to repay. Doing so is foolish and invites financial hardship, so I want to make it absolutely certain that I am not, by any stretch of the imagination, suggesting you establish this loan structure because you could not otherwise afford the repayments.
I am suggesting this loan structure to people that can afford to make the interest repayments, but choose not to – maybe because they prefer to repay their home loan, or feel more comfortable not having to commit to paying for a cash flow deficit.
This strategy is not without risks. The three main risks are interest rate increases, a depressed rental market (i.e. no rental growth) and low capital growth (which we discussed above). The interest rate risk can be addressed by fixing the interest rate on most of the debt. I have assumed a 2% vacancy rate in my forecasts. However, it is possible that your rental income my not increase in line with the property’s value. Selecting a top quality property and engaging a professional property manager will minimise this risk. The only way to address this risk is to build a buffer into the loan, to allow for a potentially larger negative cash flow.
Maybe not for everyone…but
Investing in property is not for everyone. Furthermore, borrowing 100% of the cost of the property and then borrowing the negative cash flow may also been seen as “risky”. However, I think it’s not really as risky as it might first appear. In addition, if it allows you to invest in property sooner rather than later, then it’s a great solution (and far better than not investing at all).
Please get advice
There are two things you need to do if this sounds good to you. Firstly, you need to get your own independent financial and tax advice to ensure this is appropriate for your situation. Secondly, you need to engage us to implement this structure for you. I know this sounds like a shameless plug for business (and it is!), but it is absolutely critical that the person that sets up your loan structure has a through understanding of lenders’ products (particularly lines of credit) and the relevant tax determinations. I hope you find this advice of some benefit.
Stuart Wemyss was a Chartered Accountant before establishing mortgage broking firm ProSolution Private Clients. He has authored two books and shares his experience with readers of Property Update. Go to www.prosolution.com.au
