Buying an investment property

Executive summary:

The following brief article introduces the basics regarding purchasing property to rent out. It covers taxation, borrowing and suggested reading material for new investors. This article should be read in conjunction with “Want to buy your dream home?”. Buying an investment property and finding the right investment loan requires the same care and diligence.

INVESTMENT PROPERTY, INVESTMENT LOAN AND NEGATIVE GEARING

After years in the doldrums the investment property market seems to be picking up.

Many property investors enter the property market with the view to creating long term wealth accumulation so that they may retire comfortably on the income provided by the properties they own. They initially negatively gear the property with the expectation that it will at some point become positively geared, i.e. turn from being a loss making investment into a profit generating investment. This does not happen overnight. The two main factors to consider when purchasing an investment property are the amount of rental income it will make and the amount of capital growth it is likely to achieve. Some investments are bought for their continuous streams of sound rental income but other properties are purchased with the main goal being to achieve high capital growth. Property investment is a long term strategy, is not for everyone and throws up a lot of things to be considered prior to jumping in. However, done successfully, it often proves to be an excellent tool for wealth creation.

Iden Money lends for residential investment purposes. For a few years now investment in residential property in parts of Australia, particularly in NSW, has been at a low level. In April 2004 the NSW government introduced an exit stamp duty on investment properties, which effectively discouraged potential investors. Although the tax was later repealed the market has not recovered, abetted by the dearth of development occurring in NSW. However, there seems to be light at the end of the tunnel with developers indicating renewed enthusiasm to build and with low interest rates the time seems right for investors to step back into the market. As usual, there are property hotspots being identified, particularly in Western Sydney where the sprawl westward to more affordable property and better returns on investment are being highlighted. For further information on these, click here. Iden Money can assist you to locate a suitable property through our property service.

This article explains how negative gearing works and discusses many of the issues to be considered prior to making such investments.

What is Negative Gearing?

Negative gearing occurs when the cost each month of paying for an investment exceeds the income (rents) earned from it. This net loss becomes a tax deductible expense and for PAYG earners can be claimed each payday.

When applied to an investment property purchase, there are many costs that can be included. The main cost is the cost of interest on the investment loan required to pay for the property. Some other costs are:

Purchasing Costs – e.g. legal fees, valuation and loan set up fees, Lender’s Mortgage insurance, inspection reports etc.

Ongoing Expenses – these are the day to day running costs such as:

• Loan interest on the investment loan
• Bank fees
• Letting fees
• Strata levies
• Insurance
• Rates
• Repairs and maintenance
• Accounting/Consultant fees
• Inspection costs
• Most genuine costs against the property

Depreciation – the cost of depreciating the property is tax deductible. This means that you can claim wear and tear over the pre determined life of the goods. Some examples of deductibility per annum are:

• The Building – 2.5% of construction cost (not PP) over 40 years
• Furniture – 20% per annum
• Fixtures and Fittings eg curtains, carpets, electrical appliances – 20% per annum

Why Negative Gear?

The aim is to use the parties involved to eventually pay for your property. These parties are:

• The Tenant
• The Taxation Department
• The Investor (you)

Most investors see their end profit as coming from capital growth. So it is important to realise that negative gearing is a long term investment. As the value of the property rises, so do the rents. If the strategy has worked, at some stage the income will exceed the expenses. The property is then positively geared and the investor should consider making another purchase or the profits will be taxable. The higher the investor’s marginal tax rate, the greater the benefit is from negative gearing. When the income exceeds the expenses the property is positively geared. This was your aim. Two books on this subject called “How to Create an Income for Life” and “The Truth About Positive Cash Flow Property” by Margaret Lomas discuss this in more detail and are both very good.

The Taxation Department allows annual deductions against the property as described above. However, Capital Gains Tax applies to any eventual profit, but this is not payable until the profit is crystallised ie the property is sold and the profit received. Such capital gains are taxed against either half the profit made or against an indexed figure.

Will Negative Gearing Suit Me?

There are a number of factors to consider:

1. To meet the net cost of negative gearing the investor must have available surplus funds to meet the shortfall every month. The tax benefits will help but they may not be available until the end of the taxation year. So it is important that the investor has ongoing surplus cash. A contingency amount should be held to meet unforeseen expenses eg replacing a hot water system.
2. Negative Gearing is a long term strategy, budget for at least one full economic cycle of say ten years. Even this length of time will not pay for an investment but it could produce a sound dividend if sold at this point.
3. The ability to borrow on an investment loan is essential. It is possible to borrow the full cost of the purchase plus all of the costs however you must demonstrate that your income, plus the negative gearing benefits of the property, will adequately service the loan.
4. What if the property market takes a significant downturn? Rents may fall. Perhaps interest rates will rise more than expected. Maybe you will lose your tenant for an extended period. Do you have the financial resources to dig in and see it through? Quitting a property in a deflated market can bring an undesirable result.

Summary

Traditionally, the property market has provided returns of more than 7% per annum, meaning year in, year out, the results have been sound. Thus the reason so many people have turned to negative gearing to realise their wealth accumulation aspirations, accepting losses today but reaping profits in the long term.

The ideal scenario is to find a property which has the potential to increase in value as quickly as possible, becoming positively geared and allowing the investor to buy a second and a third property and so on. The long term objective may be to sell one or two of the properties and to extinguish all debt, thereby living off the rents from the remaining properties. Unless the investor has considerable unallocated income from other sources, due to the necessity to fund the shortfall for every property purchased, the monthly cost of negative gearing restricts most investors to owning no more than 3 properties, so to exceed this the selection of each property is a major decision and is made with the view to maximising both rents and capital gains. It is possible to buy positively geared properties in some locations however you should ensure they have the potential to increase in value.

Taking the correct financial and legal advice is as important as selecting the right properties. To gain maximum taxation advantages it is essential to have the right structures in place. Most investors seem to purchase in their own names however with a little effort and the right accounting advice the use of a discretionary trust should maximise long term returns and provide greater flexibility in the use of the property and the investments that can be made.

Discuss your investment property and loan requirements with Iden Money – 1300 334 336.

Handy Hint: Be particularly careful when buying off the plan, when buying residual stock and in understanding the GST being applied to any purchase.

Disclaimer
The above article is a very brief overview of the subjects of negative gearing and property investment. Iden Money does not provide legal and financial advice and recommends that prospective investors seek independent advice. Iden Money specialises in investment loan finance. You can contact us on 1300 334 336 or send us an online enquiry.