Australia, Personal Finance, Real Estate - Written by on Tuesday, July 15, 2008 11:22 - 0 Comments

Property investment: don’t get obsessed with the tax

BRW, July 2008

Many people who purchase investment properties do so with a keen eye for the tax breaks – perhaps too keen. While approaches like negative gearing do have merit in the right circumstances, it’s important not to lose sight of the fact that the overall investment has to make sense too.

“Buying a property specifically for tax reasons is never a good reason to buy,” says Paul Moran, of Paul Moran Financial Planning in Carlton, Victoria. “I think people still have a tendency to look first at the negative gearing and second at what they are actually buying.”

Negative gearing, something of a fixation in Australia, comes when the income you get from an investment property is less than the expenses you incur on it, including the interest costs on the money you borrowed to buy it. It’s popular because you get a deduction on the difference between the two, lowering your overall tax bill. Darren Johns, a planner at Align Financial Planning on Sydney’s Northern Beaches, puts it succinctly when he calls negative gearing “a tax-effective way to lose money.”

Despite the counter-intuitive nature of seeking an investment that loses you cash, negative gearing can make sense. “The idea is that you’re giving up money today for the idea of a capital gain in the future,” says Johns. “If all property followed the golden rule of doubling every seven years – which, by the way, it does not – it’s a way to save today, pay interest and have the gain in the future.”

Chris McSwain, proprietor of RetireInvest Hawthorn, says the main issue with this approach is making it sustainable. “If an investor has a good secure income and they can essentially wear the negative gearing, and stick through the investment cycles, it’s a wonderful strategy,” he says. “Where people get caught is if they invested at the wrong time, it’s not sustainable and they have to get out.” And in this environment of high and rising interest rates, with much discussion of property devaluation in the months ahead, it’s not to be attempted without careful consideration.

Nevertheless, there are many smart things you can do with property investments to reduce your tax. They start with your own residence. “Many people buy a first home with the view of trading up at a later time,” says Moran. “They may then want to keep the first home as an investment property.” But only the residual debt on the initial property will be tax deductible from then on; the full loan for the new property will carry no deduction. Consequently, it is better to keep the loan on the initial property as high as possible, and devote any available cash to paying off the new residence.

This is where a product called a mortgage offset account is useful. Most banks offer them: they consist of two separate accounts in one, a loan account and a deposit account. The balance in the deposit account is offset against the loan amount. “Rather than reducing the actual debt on the first property, any spare cash should be saved in the offset account,” explains Moran, ”thus effectively saving the interest on the equivalent amount on the home loan.” When the new property is purchased, all the funds from the offset account are withdrawn and used as a deposit on the new property – and the full amount remains tax deductible. “A redraw home loan does not produce the same outcome, so thinking ahead is vital,” says Moran.

Another vital consideration is capital gains. Firstly, remember capital gains taxes are much higher if you sell a property within a year of buying it: all gains are then taxed at your marginal tax rate, whereas if you wait for a year after purchase, only half of the gains are taxed. Remember, too, that the gain is considered to be made when you sign the contract, not when you settle.

For people who have owned an investment property for a long time, the capital gains can be considerable, so it’s as well to think ahead about when to take the gain. “If you know you are going to have a low income year in the future, you might plan to sell in that year,” says Moran. “For example, selling a capital gains tax asset after retirement would make more sense than selling in a high income year.” If you ever plan to take a year out of paid work, that’s a good time to sell an asset where there’s a capital gain. Another option is to choose that year to make a big contribution to super to offset your capital gains tax. You still get taxed on super contributions, but only at 15%.

Another area worth considering is depreciation.  This occurs when the value of an asset reduces over time, producing a tax deductible expense. “The sting in the tail with depreciation, though, is that it reduces the cost base on which capital gains are calculated,” says Moran. “In other words, the more you depreciate, the more CGT you may be liable for.” An accountant can guide you on a suitable depreciation schedule, both for the building itself and its fittings.

As a general rule, remember that tax deductions are of more use to higher tax payers than low. And that with every cut in tax rates – such as the one that came into effect in July – the benefits of these tax effective strategies are diminished. Remember, too, that the sheer scale of individual property makes it an unwieldy investment unless you’re making it for the right reasons. “Property is a good investment overall in the long term, but the difficulty it presents is it can’t be sold in bits and pieces,” says Johns. “I have clients with a million dollars of shares and a million of property. I can stagger the share sales so they don’t get hit for the big capital gains in a particular year. But I can’t just sell a bedroom.”


TIPS BOX

  • Negative gearing might work for you, but remember a dud investment is a dud no matter how much tax it saves you
  • There’s no capital gains tax on your primary residence. On an investment property CGT halves after you’ve owned it for a year.
  • Plan ahead when you want to realise a capital gain – perhaps after retirement or in some other low-income circumstance
  • Depreciation is often forgotten and is worthwhile – but it can increase your capital gains
  • Consider an offset mortgage account if keeping your old residence as an investment property


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