For anyone who owns or is thinking of buying investment properties, the right loan strategy and structure can be implemented to save tax and maximise your wealth.
Here’s how…
Strategy #1a: Lower your non tax deductible debt
When you borrow money from the bank to buy an investment property that loan is classified as an ‘investment loan’, whereas the loan against your home, where you live, is a ‘home loan’.
In response to recent pressure from the regulator (APRA) to slow house price growth, for the first time since the early 90’s banks are now charging different (higher) interest rates on investor loans.
However the interest you pay on investor loans is tax deductible (this topic will be explored comprehensively next week when we discuss negative gearing), therefore it’s generally more tax effective to work on lowering your non deductible (home loan) debt, and leaving your deductible (investor loan) debts higher.
Note in our diagram that the borrower’s salaries and rental income are paid into a mortgage offset account, the balance of which reduces (“offsets”) the non deductible interest obligation on the home loan. This enables the principal balance of the home loan to be reduced faster as a higher proportion of the borrower’s mortgage repayments are going towards reducing the principal, rather than towards paying non deductible interest.
Strategy #1b: Move down the scale of interest rates
Your interest payments on car loans and credit cards also not tax deductible, and the interest rates charged on these products are higher than your home loan.
So when borrowers look to lower their non tax deductible debt, it makes sense to first pay off the higher interest debts — like credit cards, where interest rates can be as high as 20%+ — and then move down the scale of interest rates.
Ideally borrowers keep as much savings as possible in their offset accounts and then pay off their credit cards before any interest charges are even incurred.
The cheapest non deductible debt is generally your home loan, currently around 4.50% for most borrowers, so this non deductible debt should be paid off last.
Strategy #2: Consider interest only for your investor loans, principal and interest for your home loan
Principal and interest loans are generally the preferred loan type for your home as they enable you to reduce your non deductible (“bad”) debt more quickly.
Conversely, because it is only the interest payments (not principal) portion of your investor loan that’s tax deductible, investors can benefit from having interest only loans on their investment properties. A key benefit is that the money saved by not having to pay down principal can be used (amongst other things) to reduce the borrower’s non deductible home loan debt.
It is best practice for property investors to review their loan structures whenever interest only terms expire and the loans revert to principal and interest repayments (typically 3-5 years after establishment). Depending on the borrower’s cash flow position, and the performance of their investments, they can then consider selling their investment properties (hopefully for a profit), extend their interest only periods, or refinance.
In summary
Property can be a powerful asset class for investment, however despite any tax advantage its success or otherwise will largely be determined by the growth in value (or lack thereof) in the properties. Select your investment properties wisely and if you don’t have the time or expertise that this requires, consider consulting a buyers advocate and paying them a percentage of your purchase price (generally ~2.5%).
Property investment is best conducted when the borrower has taken expert advice from top accountants, investment/lending experts and buyers advocates.
Make sure your investments make sense from a cash flow perspective and also that the level of debts you take on match your tolerance for risk.
