Eddie Chung explains how you can use your home to buy an investment property to build your wealth and shows how to avoid the tax trap
Australian property prices have generally gone backwards in many areas following the onset of the global financial crisis and the credit crunch around the world.
Anecdotally, many speak of “bargains” to be found as current property prices in some areas are lower than what they were three to five years ago.
As the economic climate stabilises and conditions become more favourable – for example, reduction of interest rates – many homeowners may want to use the opportunity to buy an investment property by accessing the equity in their homes. But where do they start?
What does it mean?
To understand how equity can be used to buy a rental property one needs to understand how a bank considers a loan application. As a general rule, banks look at two main issues when deciding whether to approve a loan – security and serviceability.
Security pertains to the market value of the asset supporting the loan. The bank needs to be comfortable that if the borrower cannot pay back the loan and goes into default, the sale of the property will enable most – if not all –of the loan to be repaid.
Serviceability relates to the ability of the borrower to make loan repayments. Apart from security (which is a remedial measure to protect the bank if the borrower goes into default) serviceability is a preventative measure to give the bank comfort that it will not need to invoke the remedial measure.
Different lenders may have different levels of security and serviceability requirements but they invariably use the two criteria to assess a loan application.
Security is generally measured by way of the loan-to-value ratio (LVR). The LVR is basically the amount of the borrowing represented as a percentage of the value of the security. Due to the differences in risk profiles between different types of properties, banks are generally happy to accept a maximum LVR of 80% for residential properties and 65% to 70% for commercial properties.
Naturally, there are no hard and fast rules in these acceptable LVR levels – they may differ between different lenders and different types of loans. It all depends on the risks associated with the borrowings and the risk appetite of the specific lender.
A lender may, for instance, accept a higher LVR under the condition that the borrower takes out a mortgage insurance policy. In this case, the cost of the borrowing will increase as the premium on a mortgage insurance policy is significant.
In a situation where the borrower already owns a property, the possibility of loan approval can be assessed by determining if the loan on the existing property, together with the new loan on the investment property, would exceed the lender’s accepted maximum LVR.
For example, assume that your home is currently worth $750,000 and the mortgage on the home is $500,000. This would mean you have equity in your home of $750,000 - $500,000 = $250,000. Imagine now you find a good value investment unit that will sell for $350,000 and want to know if the bank will lend you the whole $350,000 to buy the unit.
You can work out your LVR as follows:
($500,000 + $350,000) / ($750,000 + $350,000) = 77%
If the bank has the normal 80% maximum LVR requirement, you will pass the security criterion. Naturally, the bank will conduct its own valuation of the properties to verify their value before concluding the LVR requirement has been satisfied.
Provided that you also satisfy the serviceability requirements, it is likely that the bank would fund the full value of the investment property without you having to contribute your own money to the purchase. In other words, the bank is effectively allowing you to access the equity in your home to buy the investment property.
Serviceability is generally measured by way of the debt service ratio (DSR). The DSR is usually calculated as the borrower’s total monthly debt repayment amount as a percentage of their total monthly income. Banks will generally accept a maximum DSR of 30% to 35% as a rule of thumb, but this may differ between lenders.
The total monthly debt repayment amount is relatively straight forward to calculate for loans already drawn down. However, debt facilities that have not been drawn down are included in the calculation.
For the calculation of the total monthly income, the lender will include your normal salary and wages (usually gross income before tax), including remuneration from a second job if you have had the job for at least a prescribed period of time to ensure that this second source of income is stable.
For an investment loan, the lender will generally allow you to include the expected rent from tenants. However, most lenders will discount the rent amount by say 25% to account for rental property expenses, as well as potential tenant vacancies.
Interestingly, some lenders may even take into account the expected negative gearing tax benefits from the rental property.
Accessing equity in your home – the tax trap
Redrawing mortgage repayments from a home loan is one of the most common tax trap investors fall into when using equity to fund investment property purchases.
While the interest attributable to the investment property is tax-deductible, redrawing the funds from the home loan to buy the investment property will effectively taint the home loan such that it will become a mixed purpose loan. To calculate the tax-deductible interest on the mixed purpose loan, an apportionment calculation will need to be done every year, which is less than straightforward and can become quite costly.
Even worse, if the investor decides to rent out their own home and uses the redrawn funds to buy a new home, the interest on the redrawn funds are not tax-deductible at all as the funds on which the interest is incurred was used to purchase a home, which is not income-producing.
An effective way to get around this tax trap is to use an offset account because redrawing monies from the offset account will not disturb the purpose and principal amount of the original loan. However, the offset account will need to be in place when the original mortgage was drawn down to purchase the home.
Another potential way to streamline the loans to ensure that tax-deductible loans are separated from non-deductible loans is to transfer the relevant property between family members or their entities but such transfers will give rise to stamp duty, so it is crucial that a cost benefit analysis be done before such a strategy is implemented.
A final word
All the above information reflects the mechanics involved in unlocking equity. Remember, different lenders have different LVR and DSR requirements. Understanding how these criteria work will enable you to know where you reasonably stand before you even approach the bank.
Given the number of parameters involved in calculating these ratios, understanding them may further enable you to pre-emptively take action to increase your chances of securing the loan. For example, you may cancel your credit cards or store cards before you apply for the loan if you know that your loan repayments may cause you to exceed your bank’s accepted level of DSR.
As usual, knowledge is power. Understanding how you could access your existing equity may well provide you with the freedom to realise your investment opportunities as they arise.
Eddie Chung is partner, tax & advisory, property and construction at BDO (Qld) Pty Ltd. Contact [email protected] or call (07) 3237 5927
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article.