When it comes to investment properties, the right advice can add thousands of dollars in extra income over the lifetime of the property. The wrong advice will cost you dearly.
This article investigates the best loan structure for an investment property, and how you can use this to deliver the most value for your new purchase.
Liston Newton Advisory has over 40 years of experience helping our clients get the right home loan for their investment property. Contact us for comprehensive lending advice plus a free investment strategy session, and discuss how we can help you make the right choice with your property portfolio finance.
Why is structure important?
Buying an investment property is exciting, but many people dive right into it, without thinking about how best to structure the purchase for the long term.
The two key structuring decisions that need to be made here are:
- Tax structure; and
- Loan structure.
Australian tax law is quite favourable towards property investing, so the tax structure of your investment property is extremely important.
The two keyto take into account are negative gearing and capital gains tax.
Negative gearing is when the expenses you pay on your investment property exceed the income you receive on your investment.
For example, say your investment property receives $20,000 in rent each year. The ongoing expenses for your property, things like strata fees, council rates, and loan interest, come to $30,000 each year.
This leaves you with $10,000 more in expenses than the income you make. Therefore, you can deduct $10,000 from your annual taxable income.
Capital gains tax
When you buy an asset, such as an investment property, the difference between your purchase price and the sale price is known as a capital gain. Capital gains tax is the tax you pay on this profit—which can get added to your taxable income.
Let’s say you buy your investment property for $1 million. You sell it for $1.5 million. This means you’ve made a $500,000 capital gain. Without any CGT exemptions or reductions, this $500,000 sum is added to your taxable income.
Where to hold an investment property
There are four good tax structure options when looking to hold an investment property.
Holding an investment property in your personal name
The majority of investment properties are typically held under a personal name. But while it’s a common structure, it’s not always the best option
Let’s look at the benefits first. A key advantage of holding investment property in your personal name is the ease with which you can apply negative gearing. For example, if you experience a $10,000 tax loss from your property, this can easily be deducted from your taxable income or business income. This makes it reasonably straightforward to reduce your tax bill.
Holding property in your personal name also means you get access to a 50% CGT discount when you sell your property. However, the drawback here is that there’s no flexibility to distribute the CGT to anyone else in your family. It all goes directly to the single owner and is payable under your name.
Another consideration is that if you own a business, it can be unwise to hold assets in your personal name. When you sign guarantees for business loans or property leases in your own name, this puts the liability squarely on you. This in turn puts your property at risk if you get into financial or legal trouble with your business.
Holding an investment property in a family trust
A family trust can be a good place to build a property portfolio. However, you need to be aware of what this means from a tax perspective.
The key thing you need to be aware of is that any negative gearing tax deductions you generate cannot be moved outside the trust. This means that you can only apply the tax losses to income within the trust.
Let’s follow on from the above example. If you hold the property in your own name and the property is negatively geared, you could apply the $10,000 loss against the income from your salary. But if you hold the property within a family trust, you can't do this. You need other income coming into the trust to be able to apply the $10,000 loss.
Alternatively, holding property within a family trust is favourable for capital gains tax. If you hold the property within the trust for more than 12 months, you’re eligible to receive a 50% discount on any CGT you may have to pay.
Another key consideration for property within a family trust is that most states will apply a higher rate of land tax for properties held in a trust.
Holding an investment property in a company
Similar to a family trust, by holding investment property in a company, any negative gearing tax deductions you generate cannot be moved outside the company. So if your investment is making a loss, the loss will accumulate within the company, unless you have other income within the company to absorb it.
Importantly too, when a property is held within a company it does not gain access to the 50% CGT discount, so you’re liable to pay the full CGT amount.
Holding an investment property in a SMSF
Holding an investment property in your SMSF can be particularly beneficial if you plan on owning the investment property in the future. This is because when you reach 65, investments held within your super account don’t attract any capital gains tax.
However, there are a number of rules of which you need to be aware, in order to enjoy the CGT-free benefits in the future.
- The investment property can only be held in the name of your SMSF.
- You can buy a residential investment property within your SMSF—but you can’t transfer an existing investment property into the SMSF.
- All investment income, and any associated expenses, must be managed solely through your SMSF.
- You can’t live in the investment property, nor can it be rented out to family or friends. It must also be rented at market rates.
What’s the best loan structure for an investment property?
When purchasing an investment property, we usually recommend borrowing the maximum amount against that property. In most cases, this will be 80% of the value of the property.
So as a general rule of thumb, you want to access the maximum debt against investment properties—because the debt is tax-deductible.
Which bank account to choose: Offset Account vs Redraw Account
Offset accounts and redraw accounts appear to work in much the same way. You make extra repayments on the loan, and you can then access those extra repayments in the future if you need them.
But when it comes to investment properties, an offset account is definitely the more favourable choice rather than a redraw. The key difference here comes down to the purpose of the debt.
Say you repay your investment property loan and then redraw that money later on to take a holiday. In this circumstance, the purpose of the amount you redrew wasn’t related to your investment—and therefore, isn’t tax deductible anymore.
An offset account is different. By making extra repayments into an offset account, the extra repayments still offset your interest. But if you were to redraw some of the funds in an offset account for a holiday, the full amount of the loan is still tax-deductible. This is because a repayment into an offset account isn’t considered a repayment of the loan, so the original loan amount stays the same.
How to make repayments: Principal and interest, or interest-only?
Your investment property is still considered a debt—but one that’s earning you money.
We recommend paying down your own home loan first before you start to pay down the loan on your investment property. This is because the debt on your owner-occupied home loan isn’t tax-deductible, whereas the debt on your home loan is.
We also recommend making a loan on your investment property interest only. Focus on paying off the principal and interest on your own home loan. Again, this is so you can reduce the non-tax-deductible debt on your home loan, and leave the debt on your investment property as a tax deduction.
In some circumstances, you may actually plan for your current home to become an investment property in the future. In these instances, it can also make sense to have this loan structured as interest-only and make any extra repayments into an offset account. But it can be a tricky one, so it’s best to consult with a financial specialist first.
How to secure your loan
If you have more than one property, a lender may want to cross-securitise the properties. This means that they have security over both properties, across two loans. But while this can make the loan easier to acquire, you should avoid this if possible.
Cross-securitising two properties makes it difficult to refinance away from the lender if you start looking for a lower rate, or at selling one of the properties. With both properties secured, it means that a decision on one property impacts the other.
The final word
As you can see, trying to find the best loan structure for your investment property can be a challenge—but it can be done. This is why it’s crucial to choose an experienced team to guide you through the process.
Going directly to a bank or a mortgage broker who doesn't understand your tax situation, or your tax possibilities means they only see half the picture.
At Liston Newton Advisory, we’re in the unique position of being not just tax experts, but financial planners and qualified mortgage brokers with our own credit licence. This means our team takes the time to understand your situation. We then help you build a long term wealth plan, get the tax structure right, and then fit that plan into the right loan product and structure.