Methods for Purchase
Many prospective property buyers ask “whose name should I place this property in?” The answer is; there a number of ways, both simple and complex, that you can purchase a property for investment. Some buyers will buy as co-owners, such as you would your own home, some will buy as tenants in common, such as friends or siblings, some will split ownership in shares such as 90%and 10 %, some will buy in the name of a company or trust, such as a family trust, and others will look to use their superannuation towards a property investment though a Self-Managed Super Fund (SMSF).
Here we will cover the most commonly used structures for purchase and which circumstance makes each one relevant for an investor:
1. Outright purchase
Maybe you have just sold a major asset, inherited money, won lottery or have a large lump sum super payout - either way you have a large holding of cash and you want to buy a property outright. The key question to ask yourself is ‘what do I want this property to do’? Are you buying it for capital growth - that is to hold for a decade or so and then sell at a profit? Are you buying for yield - that is you want a good rent return that will provide you income?
If you are just after capital growth and not concerned as much about rent and deductions you should look to purchase a residential property. You can hold it debt free for as long as you need and sell it later at a profit. Even better if you outright purchase a growth property inside a SMSF you can sell it down the track when your SMSF is in pension phase and pay NO capital gains tax. A pretty attractive proposition if you have enough super to purchase a property outright using a SMSF.
If you are after rent return then commercial property is the way to go. Again, outright purchase is attractive as you collect all the rent - however maybe look to buy using a company structure or a SMSF as they can help you pay less tax on the income from the property which will be particularly beneficial if you have a strong long term tenant and CPI increases in the rent each year.
2. Gearing into a purchase
So you don’t have a stockpile of cash to purchase a property outright. Like many you probably will need to borrow money from the banks to purchase an investment property. Using borrowed money is called ‘gearing’. Most people have heard of ‘negative gearing’ because it is the most often used form of gearing into property- it basically describes an investment where you have borrowed money for the purchase and where the outgoings are not met in full with the rent, hence the ‘negative’ tag. The common myths around negative gearing are that
(a) You can only be negatively geared into property
(b) Only negatively geared investors get tax breaks
(c) You have to have a large personal cash flow surplus to fund the negative gearing
Let’s deal with these in order.
(a) Firstly not all gearing is negative. You can and often do see investors who are neutrally geared, meaning the property outgoings are met by the income of rent and tax deductions or even positively geared, meaning the rental and tax deductions see money put INTO the investors pocket each week. Remember gearing is just the borrowing of money to purchase an investment- it does not mean you will automatically have to find extra money to fund the ongoing hold of the asset.
(b) Tax breaks or deductions to be specific are available to ANY and ALL investors who claim an income producing asset. It is very simple, if you declare income from the rent on your property as income for your individual return, then you are able to claim deductions associated with the asset such as interest on the loan, agents rental fees, council rates, insurance on the property, maintenance costs and of course the great deduction of depreciation, which gives you the tax deduction for wear and tear without you incurring the cash cost upfront. The fact is investors who start out being negatively geared will eventually become neutrally and then positively geared as the rent on the property goes up, their wages increase, meaning their tax break becomes larger and the loan on the property is paid down meaning they incur less interest each month. The deductions remain in place albeit at lower levels over time in the case of depreciation for the life of the investment- regardless of its gearing make up.
(c) Most people retreat from property investment because they believe that they can’t ‘afford it’. The common misconception is that you need to have in your budget spare cash of over $200 per week to begin to look at investing. The common mistake most make is simply taking the mortgage repayments a new investment purchase would incur and then taking off the rent and thinking that they need to cover the shortfall. This is bad arithmetic. This method of working out the cost to carry an investment leaves out the crucial inputs of tax savings your deductions will deliver and the impact of your loan being interest only or principal and interest and what a fixed rate might offer versus a variable rate. Many investors who do negatively gear are able to enter into property investment for a cost to them, after tax, of $50 to $150 per week. It is a matter of getting the flow of numbers right by talking to an expert.
How does gearing work then?
To purchase a property you will generally need two things- a deposit to cover your initial purchase at contract signing and later the funds to complete the purchase and cover costs such as stamp duty and legal fees. When you buy your home you likely saved and saved for a deposit and then went to the bank and got a loan for the funds to complete the purchase transaction. But how, with a mortgage, kids, power bills, grocery bills, sports and recreation, running two cars and all the other costs of living are you going to save another deposit for a second property? The answer is you probably won’t.
So the question is ‘where do I get my deposit’? The answer in short is - you are living in it. The majority of property investors will have a home whose value has increased over the years and decades since they first purchased it. This value increase, along with the paying down of the initial mortgage has provided that home owner with ‘equity’, the safe full of cash locked up in your home that will allow you to invest into a second property. The use of equity is basically a loan- you borrow, instead of save, your deposit. You increase your current level of debt against your home by the amount you need you make up a 20% deposit for the investment property purchase and the funds to complete come from the same place your home mortgage does- a loan against the second property you are purchasing.
Most people again fall into bad arithmetic when calculating the equity they have in their property. The common mistake is they will take their estimated home value and minus the mortgage - bingo! That’s my equity. No it’s not.
You have to remember that the equity you have only exists because of money you can borrow from a bank. The bank will not lend you 100% of your home value - typically they will lend only up to 70 or 80% of the home value. So your actual equity is: Your home value x 80% - your current mortgage.
E.g. home value of $400,000 with a mortgage of $200,000
The equity is: $400,000 X 80% = $320,000 less $200,000 mortgage = Equity of $120,000.
The $120,000 is the ‘deposit’ the homeowner has available to put towards a second property purchase.
Should the investment property be a $300,000 property the sums will go as follows:
20% deposit: $60,000
80% loan against the investment property ($300,000 X 80%): $320,000
Stamp Duty: $15,000
Legal fees and others: $4,000
Total needed: $319,000
Loan against investment property with bank A: $240,000
Equity needed from your home from bank B: $79,000
You have equity of $120,000 so after the purchase your equity will be $120,000 less $79,000 = $41,000
So what about after the purchase?
Once you have completed the purchase of the investment property using your equity and new loan you will need to manage the cash flow of the investment. The general cash flow used when negative gearing is shown below.
Assuming the investor has an income of $80,000 pa. Rent is assumed to $300 per week on $300,000 property. Interest on the equity and investment property loans is assumed to be 6%. The loan is interest only.
As the cash flow shows, the rent received of $15,288 in year one is not enough to cover the interest on the loans of $19,140 and the property outgoings of $5,361 - these leaves a cash deficit of $9,213. However this is NOT the cost to carry this investment property.
The table shows the amount of tax deductions available to the investor at ‘Total Deductions’ line to be $31,472. This is the total of all outgoing costs, interest and of course depreciation deductions. Because for these deductions available, the ‘Tax Credit (single)’ line shows a figure of $5,098. This is the saving in tax from the previous year (when they had not investment property) that the investor gains due to their deductions.
This tax credit comes off the gross loss i.e. $9,213 - $5,098= $4,115 or $79 per week. This is the REAL cost of carrying the investment for this investor.
This table cannot be used as a hard-and-fast rule, as too many variable exist in the equation such as property price, stamp duty level, loan type and interest rate, rent amount, outgoings, depreciation deductions and investor income. These will be different for every single property an investor looks at. So speak to an expert to get the math right and to see if a particular property is affordable for you.
3. Using your SMSF through a Limited Recourse Borrowing Arrangement
Where investors do not have the equity in their home or simply do not wish to use their equity, an alternate source of deposit is their superannuation money. I am not recommending that this is the right strategy for everyone and if you are thinking about a SMSF you should be well aware of the obligations and responsibilities you have by speaking to a licensed Adviser or going to the Australian Tax Office website.
I am only going to describe how this method of investment in property works. It is up to you to decide if you wish to explore it further.
The above chart shows the key components of the SMSF purchase. Let’s take it piece by piece. Firstly you have in red your SMSF. This is a simple trust that has a trustee above it and members or beneficiaries below. All super funds have this same legal structure- be they multibillion dollar retail funds or a simple SMSF with one trustee and one member. The job of your super fund is to hold your money and investment ‘in trust’ for its members/beneficiaries until retirement aged is reached and the money needs to be called upon to fund retirement income. Now as part of the investment decisions that trustees can make for their own SMSF, property has always been an available option - be it commercial or residential. The main change has been the introduction of borrowings to SMSF’s.
In the middle of the chart you see the property being purchased as an investment for the SMSF. The SMSF will put in the deposit and costs for the purchase the same as if you had a saved cash deposit to use. The rest of the funds come from the bank- just like a typical property purchase. The key difference is the type of loan the bank is allowed to write for a SMSF borrowing.
Think about your home loan for a minute. If you didn’t pay your repayments what action could the bank take, or in other words, what ‘recourse’ would it have? Simply it would be able to sell your home and if that didn’t repay all the loan monies they can take your other assets, cash and chase you into and out of bankruptcy until they get their money. This full level of recourse cannot by law occur with SMSF lending. This is because your super money is sacrosanct under law and must be protected.
You will note that under the bank on the chart that the term ‘full recourse’ is struck out and below is ‘limited recourse’. This means that in order to allow for borrowings inside a SMSF for anything - property, shares, the loan has to be limited in recourse to the asset being purchased only. That is why the term ‘security’ is in the box beneath the property - it denotes that only the property is security for the loan and that if things go bad the bank can only have recourse to the investment property, not your SMSF. This means your super in your SMSF not used for the property remains mutually exclusive to the property investment and cannot be called on to pay out the property investment loan.
So how does this limited recourse borrowing actually work? In order to protect the SMSF capital and to allow the borrowing to take place a third step in the process is needed. This is where the Custodian Trust comes into the picture. Remember that your super fund holds your money ‘in trust’ for you when you retire. The Custodian Trust (sometimes called a Bare Trust) holds the property investment ‘in trust’ for the super fund. It is the Custodian trust (which is a trust with you as the Trustees) that owns the property on behalf of the SMSF and it is importantly the Custodian Trust that takes the loan from the bank. This means that should things go badly the Custodian Trust only is called by the bank to sell the property and pay the bank back its loan. The SMSF is not liable. In order to give the SMSF the benefit of the property without the liability of the loan, an Agreement is drawn up that states simple ‘this Custodian Trust holds this property on behalf of the SMSF and ALL benefits of the property - being rent and capital growth etc. belong to the SMSF’. This means that, if the property is sold at a profit the capital gain left after the loan is repaid goes straight to the SMSF.