Australian’s have a love affair with property. Nearly six million of us own our own home and a massive 1.758 million own an investment property, with over 450,000 owning two or more.
When investors look at increasing their portfolio, the questions beg; should you turn your own home into an investment property, and if so, how do you do it and protect your capital gains tax free threshold?
Your own home, in most cases, doesn’t make an effective Investment Property. When I buy an investment property I want it to give me three things:
- Maximum growth;
- Maximum income returns and tax deductions; and
- Maximum leverage.
1. Maximum Growth
You need an investment property that will give you maximum growth.There are three key growth factors to maximise; land content, location and market pricing.
Land content is the percentage of purchase price represented by the land. I ensure at least 40% to 50% of my purchase price is represented by the land.
Where land content is only 25% of the purchase price, it means over capitalisation, as more is tied up in the house than in the land. Remember, land is the appreciating asset, so you need to maximise this.
The second growth factor is location. I coined the term;established capital benchmark, which essentially means when buying an investment property I want to have owner occupiers around me who have spent double or triple what I have. Why? It means they are recapitalising the area, ensuring continual growth.
The third growth factor is market pricing. As shown by RP Data graph below, houses in the top end appreciate but fall in value during a down turn. I prefer to stick to the lower end knowing that my house will go up and maybe bump along for a while before going up again.
2. Rental Income and Tax Deductions
The majority of renters do so because they can’t afford to buy. Therefore the best rental properties are those priced in the bottom end. Rents are more affordable and income through tenancy is ensured.
Is your house a good investment property from a rental perspective? If it’s under the median house price in your capital city, it might be. If it’s over, it may not be. You might be competing for a rental market that few wage earners can afford, resulting in weeks with no tenants.
In addition to rent, the key to cash-flow on an investment property is depreciation. You only get depreciation on a property built after July 1985, and that’s for 40 years. If you bought a house built in August 1985, you would only get 14 years of depreciation, or maybe 20% to 30% of the home value.
You can depreciate a new home 100%. This becomes a real cashflow calculation. The key to building a portfolio is duplication as the value rises. If you’re purchasing property without depreciation, the cash-flow impediment could be that after tax the property costs you $300 per week, whereas buying a newer property after tax might cost you under $100 per week. So newer is better from a cash-flow and duplication perspective due to higher depreciation.
Banks and mortgage insurers have different lending criteria for houses in different price ranges. If you are under the median house price a bank will lend 90% to 95%. Climb above the median house price, particularly above $1M, and a bank will limit it to 80%. Many banks regard this as a commercial loan, limiting borrowing to around 65%, maybe 70%.
You’ve got to look at the effectiveness of this compared to how you could leverage yourself buying houses under $500,000 where the bank may lend 90% to 95%.
The other key factor in determining whether your own property is valuable as a rental property is the current debt you have on your own house. As we all know you can negative gear property. This means you can claim all deductions on your Investment Property, including the interest on the debt.
Often people with their own home work to pay it off or pay down the principle. Let’s say you’ve got your own home worth $700,000. You originally borrowed $500,000 and worked to reduce that debt to $200,000. You then decide to convert your principal place of residence into an investment property. You can’t then gear that property up to $500,000 and claim that portion of the increased debt as a tax deduction.
In a sense you would be better off to sell your home for the $700,000, buy two or three investment properties that you can gear up to maybe 80%, and claim the interest on that principle as a tax deduction.
Now let me deal with the capital gains tax issue on investment property.
Let’s say that home you bought for $700,000 is worth $1M today, and $300,000 is capital gains tax free. If you change it to an investment property then, on the date of change, you should get a valuation, or at worst an estimation, of the value. Support this by comparable sales and that will become its capital gains tax free threshold. Anything above that from the date of change will be subject to capital gains tax.
An accountant who understands property is vital when building an investment portfolio. Too many accountants say they understand property but don’t claim anywhere near what they can, or understand the tax act as well as an accountant who does have a portfolio. I often see the difference between the successful investor and ones that struggle with cash-flow, and it comes down to the expertise of their accountant.
Like everything it is important to do homework. Start with an end goal in mind when buying a property and then ask yourself; does my principal place of residence tick all the boxes and give me an effective Investment tool that I can use to duplicate or compound at a later date?If it does, then you are off and away. Go for it.