Turning your home into an investment property- tax structuring

A lot of people I speak with have intentions to one day turn their home into an investment property.

Sadly, this isn’t as easy from a tax perspective as it first appears.

If you do have intentions to turn your home into an investment property, it’s really important you consider the tax consequences from the moment you buy your home otherwise it might not make financial sense.

In this article, I’ll explain why this is important and how you can maximise your tax deductions on your investment property that was once your home.

INVESTMENT PROPERTIES AND TAX DEDUCTIONS

One of the real benefits of investing in property is the tax deductions.

Particularly for salaried employees who don’t have a lot of flexibility about how they receive income, investment properties can be one of the best ways to reduce your tax.

One of the primary tax deductions you can receive on your investment property is the interest you pay on your mortgage.

For example, if you had a mortgage on your investment property of $800k, and your interest rate is 6%, you would get a tax deduction of $48k for the interest you have paid.

Please note that this doesn’t mean you get $48k back on your tax. This means that after you add up all of your income (including the investment property income), you can deduct your reasonable costs of managing the investment which includes the interest to determine your taxable income (i.e. the number your tax is based on).

WHY IS THIS AN ISSUE WHEN YOU TURN YOUR HOME INTO AN INVESTMENT PROPERTY?

As a general rule, when you have both deductible and non-deductible debt, you want to MAXIMISE the deductible debt and MINIMISE the non-deductible debt.

When you are buying an investment property (instead of turning your home into one), this is a bit easier to do.

Usually what you will do is borrow as much as possible for the new investment property (provided it doesn’t affect what interest rate you pay), and keep as much of your money against your home either in an offset account or on the loan directly.

This means that your home loan (non-deductible debt) is as low as possible and your investment property (deductible debt) is as high as possible.

When you’re turning your home into an investment property however, this may be more challenging as you are stuck with your existing loan structures.

SCENARIO 1: TURNING YOUR HOME INTO AN INVESTMENT PROPERTY

I’ll give you a practical example.

Bill and Tina have a home worth $1.5M with a mortgage of $500k.

Over the years, they have been aggressively paying down their loan and are really happy they have minimised how much interest they pay.

Bill and Tina decide to upgrade their house and purchase one for $2.5M.

They decide to keep their house as an investment property so they need to get a mortgage for $2.5M for the new house.

This means Bill and Tina have the following debt:

• Non-Deductible Debt (New Home): $2.5M
• Deductible Debt (Old Home): $500k
• TOTAL: $3M

This is clearly not a great outcome for Bill and Tina as over 83% of their debt is non-deductible. This can be literally tens of thousands of dollars a year and the difference between having a profitable investment property and an unprofitable one.

WHAT SHOULD BILL AND TINA HAVE DONE INSTEAD?

If Bill and Tina thought they would one day turn their home into an investment property, one strategy is to have borrowed as much as possible on the home when they first bought it and put any excess funds in an offset account.

Once they bought their new house, they could take the funds in the offset account and put it against their new home loan (either directly on the loan or in another offset account).

I’ll give another example.

Let’s say Bill and Tina have a home worth $1.5M. When they bought it, they borrowed 95% and put the rest of their savings in the offset account.

By the time they want to buy a new house, their mortgage is at $1.3M and they have $800k in the offset account.

They then buy their new house for $2.5M and use the full $800k as a deposit with a mortgage of $1.7M.

This means Bill and Tina have the following debt:

• Non-Deductible Debt (New Home): $1.7M
• Deductible Debt (Old Home): $1.3M
• TOTAL: $3M

Through a bit of forward planning, Bill and Tina have managed to increase their tax deductible debt by $800k, whilst reducing their non-deductible debt.

CAN YOU JUST REDRAW ON YOUR LOAN?

A lot of people I talk to opt to get a loan without an offset account as it saves them a little in fees. They reason that the redraw is just as good and if your goal is to simply pay down your house, that may be true.

Where the redraw let’s you down however is if you do intend to turn your home into an investment property.

If you choose to redraw to then pay for your new house, it’s likely that your interest will still not be tax-deductible.

Money on a loan from a tax perspective is treated as ‘not your money’ and any redraw can actually trigger an entirely new loan for the tax department which may not be tax-deductible.

If you are intending to do this, I recommend you get specialist tax advice as this can get complex fast.

SUMMARY

Like all things in finances, a bit of forward planning can make a big difference when it comes to your finances.

If you’re looking to take the next steps in your finances and want to avoid costly mistakes, then please reach out. We work with clients all over Australia and would love to hear from you.