Ah, the tax system

At the moment I'm knee-deep in investment options, trying to get my head around negative gearing, transactions costs and lots of other fun stuff.

Yesterday we bought a new house. For the last 5 years we've been working fairly hard to pay off our unit. We've always planned to buy a bigger place and keep the unit as an investment property. Now that the time has come, we need to work out if that actually makes financial sense.

I've been randomly tweeting about this stuff as while thinking it through, and some people have asked questions that are too hard to answer in 140 characters. So I'll attempt to go through it all here. Of course, this isn't financial advice for anyone else: it's just my understanding of my situation. It's quite likely I've completely messed this up. Once I think I have a fairly clear idea of things I'll be seeing a financial advisor. You should too.

Broadly, we're considering two options: keeping our current place and renting it out, or selling it and buying something similar to rent out. At this stage we're not looking at other investment options.

Some numbers

Lets say the unit is currently valued at X. 5 years ago we bought it for 2/3X and currently owe 1/3X. That is, we've paid off roughly half of the original mortgage.

We've bought the new house for roughly 2X. To pay the deposit and stamp duty on it, we'll be re-drawing everything we've paid off the unit's mortgage, bring that mortgage balance back to 2/3X.

The trick to working all this out is to remember to treat both loans as part of the same portfolio, rather than trying to calculate things seperately. Regardless of how things are arranged, the maximum debt we can be in is 80% of the value of the portfolio (X + 2X), ie 80% of 3X, or 2.4X.

Scenario 1: Keep the unit

Here we start with 2/3X debt on the unit's mortgage. We then borrow (2.4-2/3)X = 1.73X, which is the most we can borrow while staying under 80% total debt:equity. We have 1/3X in cash (redrawn) which takes us just over the 2X needed for the new house, with almost enough to cover the 4.5% stamp duty.

Because the unit has been owner occupied, only interest on the current 1/3X mortgage balance can be claimed as a tax deduction. This turns out to be an important part of the calculations.

So, we have a total debt of 2.4X, with the interest on 1/3X being tax deductible. The rental rate of the unit is enough to cover repayments on the exiting 2/3X loan, plus a little left over. After a year we may, if lucky, make about $5000 profit. Maybe.

Because we're making money, there's no other tax advantage in this scenario.

Scenario 2: Sell and buy

As before, we take out a loan for 1.73X and redraw 1/3X. Now, we sell the unit for X, pay out the 2/3X loan and are left with 1/3X cash (minus stamp duty etc). This goes off the new mortgage, reducing it from 1.73X to 1.4X.

Now, we buy an investment property exactly the same as the original unit, for X. We borrow all of that money, using the equity in the new house. This means we have 1.4X + X = 2.4X debt, and 3X equity. 80%. Yay.

At this point it looks a lot like things are the same as in scenario one, except we had the hassle and transaction costs of selling and buying the units. But lets look at how the debt is distrubuted.

The home loan has 1.4X debt, and has no tax benefits associated. The unit loan has X debt, the interest on which is all tax deductible. The rent we receive will not cover the repayments, and any net loss is also tax deductible. This means a proportion of the repayments we make are tax deductible.

Let's compare

Here's the crux: in both scenarios we have a debt of 2.4X and are making the same repayments on that debt. In scenario one none of the repayments are tax deductible. In scenario two, a proportion of the repayments we make (those above the rental income) are tax deductible. And, of course, a larger percentage of the interest is tax deductible as well.

What does it all mean?

If there were no transaction costs the clear winner is scenario two: same overall debt and repayments, much better tax benefits. However, 4.5% stamp duty is a significant cost. Back of the envelope, it would take at least a couple of years for the tax benefits to make up for the transaction costs. In the mean time, we have to find the cash to cover the stamp duty: we can't borrow it without going over 80%.

A rule of thumb

Basically, the more you owe on your current property as a proportion of its current market value, the more attractive it is to keep it as an investment. Provided of course than you can afford to buy a new place while keeping your total debt:equity under that magical 80%.

To me this is pretty counter-intuitive and really highlights how ridiculously complicated our tax system is.

For us, it's borderline. So borderline that I'm going to a financial planner to get them to crunch the real numbers. I think in the medium term, scenario two will end up winning out.

Thoroughly confused now? Awesome. That makes two of us.

Footnote: what's this 80%?

80% debt:equity ratio is the level below which you don't need to purchase mortgage insurance, which is quite costly and usually rolled into the loan. It's also easier to get approval if you have at least 20% skin in the game.

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