It's so important to set up the right structure for your property investments at the beginning of the deal.
If you don’t, you could needlessly cost yourself thousands (or even hundreds of thousands) of dollars in lost profits.
My friend is in the very fortunate position of owning his property outright.
It’s an investment property.
The bigger problem?
He still has significant debt over his own home mortgage.
He asked me for advice because he wants to access some of his property equity to finance a substantial renovation of his home.
I was sorry to tell him the bad news – that he’s structured his loans the absolute worst possible way and it’s costing him a small fortune – but I was also inspired to write this article.
In a nutshell, he made an assumption that many property owners make.
He thought if he borrowed money against his investment property as security, that would help make the debt tax-deductible.
This is not the case, because the ATO looks at the intention of the loan, not the security it’s attached to.
In simple terms:
When you apply for a home, the bank secures it to an asset (your home or investment property).
If you refinance to tap equity, it usually remains tied/secured to that same asset.
But the ATO doesn't care about security. It cares about the intent of the money: are you planning to use it for personal expenses, which are not tax-deductible? Or income-producing expenses, which are tax-deductible?
This is why it’s important to get the right advice when it comes to arranging finance because there are so many different ways to structure debt – and many of them are to your advantage.
Here’s where it all went wrong for my friend (and how you can learn from his mistakes).
His first mistake:
Buying a cash flow investment when he’s a high-income earner
He bought this property in 2018, under the guidance of a buyer’s agent friend who told him this regional property was going to be a cash flow goldmine.
Side note: my friend earns six figures. He lives very comfortably. He does not need any more income, especially income that requires him to pay almost 50c in the dollar in tax.
This was his first mistake: buying a property for cash flow when he would have been better off looking for a capital growth property. A growth property could have helped him offset his tax and build wealth for his future.
Better options for his situation? A property with renovation or development potential.
The second mistake:
Buying an investment property for cash
The deal seemed like a winner, so he handed over $300,000 cash (a fair whack of his savings) for the home.
He never took out a mortgage, so every dollar paid in rent as additional income.
But as I mentioned, every dollar is highly taxed.
Instead of paying cash for the property, he could have:
Refinanced his own home to withdraw equity to use as a deposit and cover stamp duty.
Split his home loan so this part of the debt is clearly separate from the rest of his debt. That way, the interest is accountable and tax-deductible.
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Taken out a loan for the remainder of the property.
In total, his tax-deductible debt against the investment property would have been around $330,000.
Even factoring in current ultra-low interest rates of 2%, this amounts to $6,600 a year in interest he could be claiming against his income tax.
Over the last 3 years, that’s around $20k worth of tax deductions he hasn’t claimed. He pays the highest level of tax, so that’s $10,000 he’s missed out on.
As an added benefit, that $300,000 could be sitting in an offset account against his own home loan.
That means he’d be offsetting the interest payable and paying more towards the principal each month, helping him own his own home outright sooner.
How much did he miss out on in total?
The news for my friend is not all bad.
His property is now worth $450,000, and his own personal home has grown in value too.
He can access equity from either property to fund his renovations, but unfortunately, it won’t be tax-deductible.
However financially, he’s missed out on some massive savings and benefits.
First, there’s the loss of tax-deductible debt on the mortgage.
We worked out that it has cost him about $10k.
Then there are the benefits of offsetting that he’s missed out on with his own home.
Rough calculations show he’d have paid off about $20,000 more of his home loan principal, if that $300k had been in an offset against a mortgage of 2%, rather than invested in a property.
And let’s not forget the rental income.
Over the last 3 years, he’s received around $400 a week rent, once management fees and council rates were subtracted.
That’s roughly $20,000 a year or $60,000 over 3 years.
He’s paid almost 50% tax on this income, so he’s handed over around $30,000 to the taxman for no good reason.
If he’d taken out a loan as outlined above, his rental income could be offset somewhat (to the tune of around $6,600 a year) by mortgage expenses.
This means instead of paying tax on $60k income, he would have only paid tax on around $40k. That’s another $10k in savings.
All in all, the wrong property structure has cost him roughly $40,000 over the last 3 years.
Unfortunately, there’s nothing he can do about it now, as the deal is done.
He is paying a hefty price for not getting the right advice back at the beginning.
If he’d worked with an accountant or mortgage broker worth their salt, they would have shown him different, more tax-effective options when it comes to structuring the deal.
My advice to you?
Learn from his mistakes and invest in the right advice upfront, so you don’t end up paying more down the track.