Investment properties come in all different shapes and sizes, and property investors have different life situations and financial positions. Therefore, the trick is often a case of matching property investors with the right types of properties that best suit their specific circumstances.
Capital growth vs cash flow properties
The total investment return on an investment property generally comprises both income and capital gain. As a broad proposition, the total investment returns of different properties do not generally differ a great deal, but the proportion of income and capital gain may materially differ. At one end of the spectrum, there are properties that produce a high level
of rental income but have limited capital growth potential (‘cash flow properties’); at the other end, there are properties that yield minimal rent but have a large capacity for capital growth (‘capital growth properties’).
For instance, student accommodation often produces a constant flow of rental income due to its proximity to major educational institutions, but given its compact size and limited features, as well as a general lack of land content, its potential for capital growth is more often than not limited. On the other hand, a dilapidated Queenslander or a rundown Sydney terraced house in a superb location may yield limited rental income due to the physical state of the building, but its prime and highly sought-after location may have an enormous potential for capital growth.
Capital growth properties
Younger people who are working towards or at the peak of their careers are usually at the height of their income-earning capacity. Therefore, a young person may not need additional income from their investment property to supplement their living expenditure during this stage of their life.
Coupled with the fact that any net rental income derived from the property will be assessable income for income tax purposes, owning a cash flow property may have the unwanted effect of maximising their tax liability, especially if they are paying tax at the highest marginal tax rate.
Accordingly, for these people, it would probably be sensible to look for investment properties that yield minimal rental income but have a greater potential for capital gain. In addition, gearing these properties by way of a higher level of debt will further reduce their tax liability as the interest on the loan will be tax deductible against the rental income.
The key objective here is to minimise income tax by minimising the amount of net rental income derived from a property during the highest income-earning years of the individual’s life, and ‘locking’ the investment return on the property in future capital gains. When they eventually wish to transition to retirement or retire altogether, they can then consider selling the property to realise the capital gain. Provided that the property has been held by
an individual or a trust for at least 12 months, the capital gain will qualify for the 50% CGT discount.
Depending on the individual’s taxable income at the time, the maximum tax payable on the capital gain will be limited to about 25% of the capital gain, as opposed to up to 49% tax on the rental income had they derived a higher amount of rental income during their working life, which is a good tax outcome.
Cash flow properties
As an alternative scenario, older people who are transitioning to retirement or have retired will generally often prefer to buy properties that maximise cash flow, with limited capital gain, unless they have sufficient other sources of income to meet their needs.
At this stage of life, the ability of an investment property to generate a constant flow of income is an important feature that will allow many to maintain their lifestyle. This often coincides with that time of life when some or all of the debt on the investment property has been paid down or paid off, which will maximise the rental income due to the lower, or absence of, interest expense on the loan.
From a tax perspective, provided that their taxable income, including the net rental income from the investment property, is not excessive (taking into account that a retirement pension from a superannuation fund is generally not assessable and therefore not included in taxable income), the tax payable on the net rental income may not be as high as it would have been during their highest income-producing years when they were paying tax in a higher tax bracket.
And what about capital gains tax (CGT)? The reality is that given the reliance on cash flow from the property to maintain lifestyle, there will be limited incentive to sell the property. After all, if the property is sold, the cash proceeds will have to be invested in other assets to fund one’s retirement, so it may not be sensible to crystallise a CGT liability by selling the property and then have less after-tax capital to invest in an alternative investment, which will in turn deliver a lower level of income flow.
Fast-forward to the end of one’s life. Under the current rules, if a property is inherited by a beneficiary, they may also inherit a CGT liability. However, most people will quickly come to the realisation that this means the tax will become someone else’s problem, not
to mention that the beneficiary will have the proceeds from the sale of the property to fund the tax liability anyway, which is not an unfair outcome given that they have inherited the property for nothing.
As mentioned at the beginning of the article, your life stage and individual circumstances will often dictate whether you should buy a capital growth property or a cash flow property, given that these different types of properties have different ROI profiles that may have a direct impact on the total tax you have to pay on the investment property during your lifetime.
Choosing the right type of property to suit your purpose may have a material impact on your overall wealth and financial security. The investment should be part of your overall financial and wealth creation plan on which advice should be sought from a qualified investment adviser. The only thing left to do then is to find the right property that will achieve your objectives, which will involve some number crunching and website trawling. Good luck with your quest!