Episode 27: Investment Properties and Lending (the deductibility of finance)

July 12, 2021

Ever considered converting your current home to an investment property and buying the home of your dreams? This episode is for you!

Sarah and Trudi explain for you in this episode the implications of decisions made when it comes to converting your own home into an investment property. They cover what’s deductible against your tax, what negative gearing means, the deductibility of interest and how to structure your investments loans to achieve the outcomes you desire.

They explain what “purpose of funds” means within the ATO and Lenders definitions, and qualify what depreciation is and why you should get a Quantity Surveyor to provide a report for you on conversion of your property to an Investment Property.

Podcast Transcript Available Here

Duration: 22:05

Trudi Cowan: Hello, hello, hello, welcome back, we are chatting about investment properties today. Sarah Eifermann: Yes, investment properties and the deductibility of financing specifically. I had a couple of questions over the years but more recently in the last couple of months with people, not potentially understanding the implications of what they do in their loans. Trudi Cowan: Yeah, and I get a lot of questions about can I do this, and can I do that in terms of the investment loans? Sarah Eifermann: So in talking about investment properties but we're also going to talk about what if you want to convert your invest your current home, which is known as owner-occupied property into an investment property and the implications that go with that in terms of the lending. Trudi Cowan: Yeah, and I think that the principle that I want to start with. Yeah, is that when the HEO looks at whether your loan, the interest on your loan is deductible for tax purposes, what they are looking at is what is the purpose of you borrowing that particular amount of money. Yeah, okay. So, if you are borrowing for investment purposes, then that interest should be deductible. To put an example around it, you could be borrowing some money to buy an investment property, but you are securing that loan against your home. The HEO doesn't care what you're using as security. What they care about is that you borrow that money so that you could go out and buy an investment property and that rent on that investment property is going to be assessable and create an income. Yeah, so it’s really important to understand the purpose of your borrowings, and the purpose of your refinancing and the purpose of any redraws of money off your loans, because that is what the HEO is going to look at. Sarah Eifermann: And your mortgage or finance broker may refer to that as the purpose of funds. Yeah, that's the common jargon term, its purpose of funds. So you can't claim purpose or funds for non-investment debt. Yeah, that would be the standard line right, so if they know what they're doing.  Trudi Cowan: And I think that where people often get tripped up is where they've got multiple loans. And they mix their money too much, instead of being very specific that this loan is for investment purposes only, maybe that loan was actually partly for the house it was partly for the granny flat or partly for the house and partly for the deposit on the investment loan. When you start to mix those monies up, it gets a bit more confusing and a bit more difficult to split out the component of interest that may be deductible. Sarah Eifermann: Well it can be done but you end up paying your accountant through the roof, so I always had a really strong line on this. One for compliance for myself but two for my clients that the last thing you want to be doing is paying your accountant 1000s and 1000s of dollars in time to go through what could have just been solved by having what's called a split in a home loan. So yes, we always did loans, separately, and a good broker will they'll say this is your personal debt your owner-occupied debt, and this is your investment debt, And they get separated, and they don't get mixed or muddled up because it's just way too confusing and creates problems if you ever get audited. Trudi Cowan: And look, and you know I, in particular, you know, if you've got five investment properties, then I would actually prefer to have five loans because they can very specifically say that loan one relates to house one. Loan two relate to house two and so on and there's no mixing cross-contamination. It's really, really clear to everybody involved, that that interest relates to that house, and that rental income. And you know, and you might go, Well, I can figure that out of the rent, okay well what happens when you sell one? Yeah, That right, and what they'd like what then happens to loan. When you’ve sold one of the houses? Sarah Eifermann: You have to do partial discharge and then the lender may not release it and that's called cross-collateralized, and it all becomes very convoluted and over the top and it was not, there's a time and a place for that type of lending. But in this day and age with the freedom and flexibility of products that are available with a little bit of thought into the process and the right lender, you can really achieve some amazing outcomes in terms of structure and one of the common questions that were oh, do I really need all these loans splits, be like, yes you do because your accountant will love you for start, but it makes it much easier to do lots of different things as you've just said. Trudi Cowan: Yeah, let's maybe put a couple of examples around, I think, to explain this best, you know, let's say I’ve had a client come to me and say, I’ve got this investment loan, but I’ve paid more on to it than I had to. So I’ve got some available on this investment like, right, but I want to take the money out and go do some renovations on my personal home that are leaving. Yep, does that mean I’ll get a bigger interest deduction this year because I'm increasing how much I owe to the bank? The answer is actually no, yeah. What's happened is that by paying money onto the loan, you have paid down that investment loan. Right. And then you've done a redraw. What the HEO will look at is okay well what was the purpose of the redraw. Yeah. And the purpose of the redraw in that example was to use it for private purposes in your private home. Sarah Eifermann: Yes, it wasn't to create a new income stream. Trudi Cowan: No. So the HEO will actually disallow any interest on that redraw component.  Sarah Eifermann: That's why you put it in a separate split. So if the loan was $100,000 of which 70,000 was for the investment property and 30,000 more for renovations on your property, then you split the loan 70 30. Trudi Cowan: And that's why we love an offset account. You know, if you want to have more money paying down your investment loans, then only pay what you have to pay your minimum payments on the loan and put any extra into an offset account. Sarah Eifermann: But it's the same thing as a redraw, which is what most people say to me. Trudi Cowan: But it's not okay because if you put it into the loan account that is a repayment of your loan. Sarah Eifermann: Correct the balance has reduced. Therefore you have reduced the principal outstanding. Therefore, the balance that you can then claim interest on is the lower amount regardless of if you take money out of that loan. Trudi Cowan: That's right, whereas an offset account. That's not repayment of your loan. That's just a bank giving you  Sarah Eifermann: It’s a bank account, that gives you an offset of interest. Trudi Cowan: And the bank has an agreement with you that they'll reduce your interest because you've got some money sitting in this bank account. That's not repayment. So pulling money back out of that account doesn't impact the loan account and the interest that you're incurring on that loan. Sarah Eifermann: You're going to need to say that again because it's not they haven't explained it well. Usually, this is the point where I get a blank face from clients because they go, but it's the same thing. It's not the same thing guys. Trudi Cowan: Think of your offset account as a bank account, forget that it has an impact on the interest that you're paying on your loan. Is just a bank account. Okay, if you're putting money into that all you're doing is putting some savings aside. Sarah Eifermann: Whereas a loan with a redraw is a loan facility.  Trudi Cowan: Yep, so you put money into that loan account, then you are making repayment of that loan. Okay. Any redraw of that is a new loan might still sit in the same balance the one account the one statement you get from the bank, but for your tax purposes, it is considered a new loan, a new amount that you are borrowing, when you do the redraw. Sarah Eifermann: And if the purpose of funds is not for that specific investment property or another income-generating investment, it's private use. Trudi Cowan: Then it'll be non-deductible interest.  Sarah Eifermann: So I have a house that I live in, and I want to convert it into an investment property in a couple of years, but it's currently worth $500,000 For example, and I owe $300,000 But I’ve got 50k in the redraw and three years I'm going to take that 50k and go out and use it as a deposit and get another loan and buy a new house and move out and make this an investment property, how much can I claim in a couple of years? Trudi Cowan: Well that 50,000 is going to be a new loan.  Sarah Eifermann: For personal purposes? Trudi Cowan: For personal purposes so even though you had an original 300 owing, and then you  Sarah Eifermann: 350  Trudi Cowan: Sorry 350 owing, I need the 300 because the 50 is taken as the redraw. I need the 300 that is going to be delectable interest on that loan. Sarah Eifermann: So if you've paid down your owner-occupied house. Your head overpayments. You've cash banked in your redraw if you convert it to an investment property in the future, which you can do. You cannot claim a deduction on more than the current balance at the time of conversion.  Trudi Cowan: That's right.  Sarah Eifermann: And that's the bit where people get confused because guess what surprise, they don't plan what they're doing in the future.  Trudi Cowan: I know I'm a broken record with this.  Sarah Eifermann: But I’ve seen it too many times where people have gotten burned, they've had all the right intentions they've tried to do the right thing, but they've put it into the redrawing of the loan, not an offset account, and this is a common argument and it's going to come up more and more and more with ASIC, saying we'll offset accounts usually cost more, and with the best interest, Judy coming in, should you be getting an offset account with your loan.  Trudi Cowan: Yeah. Yes, always. Sarah Eifermann: Exactly. You heard it from the mouth of the accountant, that always gets an offset account, always gets an offset account. Trudi Cowan: It allows you to have that planning and flexibility.  Sarah Eifermann: Yeah, and use the offset account and pump as much cash into the offset account, as you can. And look, there are some amazing features now that you can use where there are multiple offset accounts that still offset one loan accounts so you can have, they're called sub-accounts or sub offset accounts so you can have a main offset account and you can split it Barefoot Investor 20 different ways style. And have you fire extinguisher accounts and yada yada yada. I really don't care as long as the money's in offset. Trudi Cowan: Yeah. Now the other example that I sometimes hear is, we bought a house for 500. We only owe 300 on it now, but it's now worth a million dollars. Yeah, right. We want to go and buy a new house to live in, and we're going to turn this one into an investment property. But what we're going to do is because of equity in this house we're going to borrow, and put the collateral against this house because that's going to become an investment, and when I get to claim all the interest then? Nope. No. Again, no. Sarah Eifermann: Purpose of funds. Trudi Cowan: Yeah, and in this case, the purpose of the funds is to go and buy another house which you are going to live in, and therefore not be making any income on. Okay, it doesn't matter that it's secured against the investment property. What matters is that you're using that money to buy a personal property to live in. And you know, we've probably got a few other examples, but they all centered around the same thing of looking at what is the purpose of that borrowing. Sarah Eifermann: Yeah, and I suppose that then leads into with, then what is deductible on investment property, and how that works if you then convert your owner-occupied home to an investment property, what becomes deductible or claimable? Trudi Cowan: So, you're obviously earning rental income and that's the income that you're receiving. Sarah Eifermann: That you would pay tax on because it's income.  Trudi Cowan: Yes, that's right. So, you're obviously the interest on the relevant component of your loan can be deductible, and then also the other I guess running costs of the property that you might have to pay. So we're thinking things like your council rates, your water rates, So your tenant will pay the water usage, but you'll still pay the water rate component. Sarah Eifermann: Provided there's an individual meter. Trudi Cowan: Body corporate fees if you happen to if they're relevant for you. If you have any bank fees so a lot of investment loans might have an associated annual package fee or something like that. That's deductible. Also, if you need to do any repairs on the property. So for example, if a pipe bursts and you got to get a plumber in those costs to fix that pipe will be deductible. If the hot water service goes, And you need to get new hot water service in. That's considered replacing a new asset component of the property, and you can claim depreciation which means you can claim the costs, you've just got to do it over a period of time, rather than all in the one. Sarah Eifermann: Yeah, now I’ve had my house for a few years, I put a brand-new kitchen in 12 months ago. And next month, I'm moving out and it's becoming an investment property, can I claim, the cost of my kitchen? Trudi Cowan: You probably can't claim the cost between you putting it in and you move out. Yeah, but you will be able to again depreciate.  Sarah Eifermann: Yep. And how do I qualify the depreciation that's available? Trudi Cowan: If you've got receipts and invoices, we can usually calculate it based on that. But what I would often suggest to my clients not just in that circumstance but also when you've just bought a new investment property, you don't know the cost of any of it, is you can go and get what's called a Tax Quantity Surveyors Report, and they will basically come in and estimate the cost of both the build itself, as well as the individual assets, within the property, and they'll also calculate what depreciation you'll be able to claim. Sarah Eifermann: Are they still around 350 $500. Trudi Cowan: Yeah, they're on around that to get a report done.  Sarah Eifermann: Yeah, okay. Trudi Cowan: Okay. And these guys are experts in both the building side of things and the value, the cost of the construction, as well as having tax expertise. So these reports are recognized as being appropriate by the HEO to use to claim those relevant depreciation costs. Sarah Eifermann: So I move out of my property, I claim my depreciation, and in three years, I sell it. What's it going to cost me then to sell? Trudi Cowan: You're going to have Capital Gains Tax. Sarah Eifermann: Why? Trudi Cowan: Well, there is the main residence exemption. But there are lots of complex rules around. You can only have one main residence at a time. Sarah Eifermann: Yes okay Trudi Cowan: So assuming you moved out of that property and moved into a new one. One would think that new property then becomes your new main residence, yeah. Okay, so there's going to be, what do we say a three-year period that that property was rented for. Yeah, you can't claim the main residence for that three years because you're claiming it somewhere else. Right, okay, so you may not pay tax on the purchase price, less sale price. Yeah, right, but you still will have to pay for a period that is calculated with respect to those three years that you've rented it out. Sarah Eifermann: Just to qualify, Capital Gains Tax is charged on investments of all kinds? Trudi Cowan: Yes.  Sarah Eifermann: Stocks shares, bonds, and property. So, when you convert it to an investment property that is why Capital Gains Tax applies. And if you get the value benefit for claiming depreciation, you then pay tax when you sell the asset.  Trudi Cowan: That's right.  Sarah Eifermann: So, I suppose that now is a good time to talk about the difference between the types of gearing, then, not a lot of people understand that the niggly bits of gearing that if they're familiar with the terms, negative geared or positively geared. But they, don't understand, particularly the concept so how about we run through the concept of gear.  Trudi Cowan: So basically, the negative and positive just refers to whether you're making a profit or a loss on that property. So if you've got a negatively geared property, you're making a loss.  Sarah Eifermann: Okay if you've got a neutrally geared property? Trudi Cowan: You're making zero. Sarah Eifermann: Yeah, neither here nor there.  Trudi Cowan: So really, you know it to put it.  Sarah Eifermann: If you're making a positive you've got a positive good property, you're making a profit.  Trudi Cowan: That's right,  Sarah Eifermann: So the costs of the property, do not outweigh the income that's coming in so you're still in the surplus, not the red. Trudi Cowan: Yeah, so the thing you need to consider is if your rent is not covering your rates and your interest and insurance are other ones, we can talk about the corporate fees. The costs of having that property, you might actually be out of pocket Cash Wise, to have that property because you still need to cover all of those costs, if you're negatively geared, whereas if you're positively geared. You'll probably be making an income, even after all of those costs. Sarah Eifermann: Yes, and you'll pay tax on that income,  Trudi Cowan: You will pay tax on that whereas if you're negatively geared, that negative gearing will help to reduce your other income, so your wages for example potentially in your tax return. Yeah. Sarah Eifermann: Cool lots and lots of crazy information in that one, I say crazy in the right way. Trudi Cowan: In the right way. One other thing I did just want to cover off before we finish is the difference between a home loan and an investment property loan. Because they're not the same thing. Very similar, but there are some small differences.  Sarah Eifermann: Explain.  Trudi Cowan: Well for the one obvious one an investment property loan, you pay a high-interest rate. Sarah Eifermann: Okay so these are more recent changes than they used to be, they used to be no difference between principal and interest repayments on a loan, home loan, or investment loan in terms of the rate change. And about six years ago, the government decided, and the RBA and Appro and all the other financial institution ASICs Yep, pretty much alphabet soup. They got involved in decided that they weren't happy with the debt levels that Australians had naturally, even though we hold the lowest, you know, can we have a lot of credit card debt, but the mortgage debt isn't as high as other parts of the world. And so they were now going to start forcing people to make repayments on their loans, and they were changing the marketplace based on that. So principal and interest loans became the favorite, therefore you got penalized if you had an interest on loans, the rate hiked. And then if you had investment debt, the rate hiked again. So, Yes, they are now, fundamentally structure-wise, there's no difference between the loans, how they work. The operation of them. But the purpose potentially can have an impact on tax.  Trudi Cowan: If I don't tell my bank that it's going to be an investment property, do I get into trouble? Sarah Eifermann: Not with the bank, per se because, you know, what they don't know they don't know. But you are making a declaration. Yep. So, it comes back to that whole What's your disclosure, what have you signed, What's your declaration? Trudi Cowan: Make sure you're reading those documents to know what you are signing. Sarah Eifermann: I mean, people genuinely have moved out of their property converted it to an investment property, and just not even considered that lending has changed right, especially if it's a fixed-rate loan because you'll end up paying a massive break cost to break the contract so again planning. Yeah, and all of that and how that comes together but I have heard, and you can confirm this that if the loan doesn't say investment loan on the statement, you can't claim it. Even though the purpose of funds. Trudi Cowan: Well, HEO would probably use that as part of their evidence  Sarah Eifermann: To say it's not actually an investment property because the loan isn't, doesn't say investment loan so something to consider. Trudi Cowan: And it would just be one element, you would probably need to put in the work to show the extra things so for example If it were an Airbnb, but you weren't using an Airbnb type service, it might be more difficult to for you to argue  Sarah Eifermann: To qualify and quantify the income.  Trudi Cowan: Yeah, and therefore if you're, tentative for 12 months you are going through, you know Ray White or berry plant and manage it you've got other supporting documents to support the fact that it is an investment property, so the fact that investment wasn't on your loan, that would just be one element, it would then be whether you've got the other things to support that it is actually rented out and you're earning income from that property.  Sarah Eifermann: Yeah, completely, completely. Wow, lots of information there I already know all of this stuff and even my mind's exploding right now.  Trudi Cowan: As always, we'd love to hear your thoughts, comments, questions, let us know if you've been tripped up by some of these rules and things around investment properties. Sarah Eifermann: And have a good I think about if you are going to convert your property. What you do with the funds, and where you place money now. Yeah, so if you're thinking about it in the future, where you put money now is really important, because if you're paying down the loan, but for affordability, you need the deduction on the interest to make it work in the future, you may be shooting yourself in the foot without even realizing it. Trudi Cowan: And if you don't have an offset account, even if you don't have plans go talk to your bank and get one. Yeah, or speak to your broker. Sarah Eifermann: Or speak to your broker and get a refinance structured done, because sometimes you can't just add an offset account you need a particular product that allows you to have an offset. Trudi Cowan: Quick last question. How often should I get my loan renegotiated on my investment property? Sarah Eifermann: Again, depends on the property type because if you fixed it, you can't renegotiate but I would say every six to 12 months at least.  Trudi Cowan: Yeah, so if you haven't done that recently guys. Yeah, go chat to brokers. Sarah Eifermann: It's a pricing request in case you're not sure what it's called. I'd like a pricing request on my current loan that doesn't mean you have to move. Just get them to go back to the bank and ask questions. And if you straight to bank ring them up and go, I want a cheaper rate, yep, I want the cheapest rate you can give me. These other lenders would give me X Y, Zed. This is what I'm expecting and let them come to the party and tell you what they're going to give you.  Trudi Cowan: Yeah, definitely. We'd love to hear your successes on that one. Sarah Eifermann: I'd love to hear, I really would love to hear your successes on that one because they are very interesting, very, very interesting. Alright guys that's all we've got time for today again as always if you've got any questions, please please please shoot them through. I'm Sarah Eifermann.  Trudi Cowan: I'm Trudi Cowan.  Sarah Eifermann: Have a great afternoon.  Trudi Cowan: Bye.

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