Written by Kris Wrenn – Senior Adviser
ALL MEMBERS SHOULD SEND THIS TO THEIR ADULT CHILDREN THAT HAVE NOT PURCHASED A PROPERTY BEFORE.
If you have just started out in property or are considering it, good on you! Buying property in Australia has arguably been one of the best growth assets for over 100 years. As long as you buy smart and you hold for the long-term, I have little doubt in my mind that you will be successful and will thank yourself years down the line. BUT, when first starting out, there is a big decision to be made in terms of whether you buy to live in the property, lease it out, or perhaps, a combination of both (I will come back to this). There are numerous pros and cons relating to each option, including a minefield of state laws and tax legislation that impacts each differently.
Principle Place of Residence (PPR)
Maybe it’s your first time moving out of Mum and Dad’s place? Or perhaps you have been renting for several years? Either way, something in you says you want your own place. So, you speak with the bank (better yet a Hudson mortgage broker), you determine your borrowing capacity and you find the best property you can for the price you can afford in the area you want to live. Before you know it, you are no longer paying someone else’s mortgage, you’re paying your own and, in theory, in 25 years when you make that last mortgage payment it will be yours. There are plenty of positive outcomes here! It’s like being your own boss … you don’t get unexpectedly moved on by the landlord, you can paint the house purple and you can let your Labrador live in the house. (That one’s not for me, cuddly as he is, he moults like a fiend).
Another positive with a PPR is tax related. In this instance as the years progress you are not building up a capital gains tax implication. This is because the Government allows for a “Principle Place of Residence Capital Gains Tax Exemption”. (If you’re not sure what capital gains are, see below section relating to buying an investment property).
Further on tax, buying a PPR comes with inherent negative tax implications, in that the multitude of expenses related to both initially buying and then owning property are not tax-deductible. Let’s run through a list of expenses that will likely apply <warning – this is not for the faint-hearted> …
Initially you’ve got Stamp duty, Legal fees, bank fees, mortgage insurance?, moving costs and maybe renovation costs if it’s a fixer-upper or if you just want to personalise it. Wait, you’re just getting started … once you’ve settled on the property, there’s obviously the monthly mortgage payment, council rates, electricity bills, water bills, home and contents insurance, body corporate costs (if applicable). And that’s if nothing goes wrong … be prepared for the air con or the water heater to pack in. In summary, owning property isn’t cheap. And if you’re an owner-occupier, the tax man has no sympathy.
Investment Property (IP)
In contrast, when you have an IP, almost all of the expenses I listed above are tax-deductible. They are usually tax-deductible in the financial year that they are paid. Or, they may form part of the cost-base to save you capital gains tax in the future (see below). Finally, there are numerous items that an investor can claim as “depreciable”, another form of tax benefit in that such claims reduce taxable income. The higher your income the more tax effective all these deductions are. If you are blessed enough to earn over $180,000 you are victim to one of the highest tax rates in the world, currently 49%. So this means 49% of these expenses/depreciated items back in your pocket.
Just as with a PPR, there are positive tax implications as above, but there are also negatives, the main one being that as time goes by you build up a “capital gains tax” liability. That is, if the value of the property rises in value and if you then sell it for more than you paid, the difference is known as a capital gain and at least a portion of this will potentially go on to your taxable income, commonly referred to as Capital Gains Tax, or CGT. I say potentially because it’s not as simple as just deducting the purchase price from the sale price. There are numerous expenses relating to the purchase that can be used to increase the cost base (thereby reducing the gap and reducing the tax). Likewise there are numerous expenses related to sale that can effectively come off the sale price, again reducing the gap and the tax paid. Some forms of depreciation claim will reduce the cost base, which widens the gap and increases the tax to pay. Finally, if you hold the property (investment) for longer than 12 months, then just as with most investments like shares, you can claim a 50% CGT discount.
Time for an example
Two brothers John and Andy are both (coincidentally) going to buy their first property at the same time. John is in a serious relationship and is planning to start a family so he decides he’s going to buy a PPR. Andy is less settled so he decides to buy a property as an investment and will lease it as soon as possible. Assume the following:
- Both properties cost $500,000 and the value rises to $650,000 ($150,000 capital gain) across the next 5 years, at which time both brothers will sell, and the costs of selling (namely realestate agent commission) are $15,000.
- Both John and Andy put the same deposit down and so borrow the same amount.
- Both John and Andy earn $90,000 p/a so are in the 34.5% tax bracket.
- Andy leases his property for $450 p/w and then rents for the same.
- Initial Expenses are: Stamp Duty and other purchase costs $15,000. Ongoing expenses are: Interest on loan $18,000 p/a, Rates $1,600 p/a, Water $1,300 p/a, Body Corp $2,000 p/a, home insurance $500 p/a. So total ongoing expenses $23,400 p/a. (Electricity will be ignored as it is paid by owners/tenants alike).
- Depreciation items total $12,000 p/a.
This one is simple. John pays all of the above expenses each year, and when he sells his property, he claims the “Principle Place of Residence Capital Gains Tax Exemption” and pays no tax on the capital gain. He does however have the expenses related to sale ($15k) and so ends up with $135,000 in the bank. Depreciation is irrelevant.
This one is more complex. Andy receives $23,400 in rent from the tenant each year which is assessable income, BUT the expenses (coincidentally) equal $23,400, all of which are tax-deductible, so the net effect on his tax to pay is Nil. He claims the $12,000 depreciable items each year, saving him $4,140 in tax each year. When he comes to sell he has the same $150,000 capital gain as John and the same $135,000 in the bank after expenses. Andy then has to think about CGT given he has a $150,000 capital gain … three things influence this: 1/ the cost base rises by the initial expenses of $15,000, 2/ the sale price falls by the sale expenses of $15,000 and 3/ the cost base reduces by $60,000 due to the depreciation claims, so net capital gain $180,000. He then claims a 50% CGT discount because he has owned the property for over 12 months, so this reduces the amount going on to his taxable income to $90,000. Based on his income, tax to pay is $33,750.
So in this example, Andy saves $4,140 each year in tax, which totals $20,700 but pays $33,750 in capital gains tax, so he ends up $13,050 worse off than his brother. One way to mitigate this is that Andy could choose to rent somewhere cheaper than he leases his own property. E.g. If he rents for $350 p/w, he saves $26,000 compared to above and ends up around $13,000 better off than brother John. Many would argue however that this is not ideal. So, is there a better way …?
INTRODUCING … the 6 year rule. This is the commonly used term for the fact that the Government will allow individuals to extend the PPR CGT exemption for a very generous 6 years after a PPR is leased and turned into an investment property. i.e. As long as you live in your property initially, as such making it your PPR, and then move out and lease it, there are no capital gains tax implications for up to 6 years from that point in time. Please note, this does rely on a few things … firstly you cannot own another PPR (so the most common instance is that the person then goes and rents a property). Secondly, there should be legitimate reasons why the individual is moving out and leasing the old PPR. If they rent the property next door and their only reason to do so is paying less tax, this would not be viewed favourably by the ATO!
Using the 6-year rule means you can benefit from various pros of both PPR and IP. You enjoy the ongoing tax benefits of an investment property (not the initial because it was bought as PPR) and you also avoid the capital gains tax for the 6-year exempt period. Contrary to popular belief, you don’t need to sell the property or move back into it within 6 years. If you own the property beyond the 6-year period that it is leased, you can still claim the exemption for the 6 years, it’s just that a capital begins to build up from the 6-year mark.
Working this into the example with John and Andy. Let’s say Andy, we’ll now call him “Smart Andy”, chooses to adopt the above strategy incorporating the 6-year rule, it might look a little like this:
- Smart Andy buys the $500k property and moves into it. After 12 months he decides he is going to move to a different location to rent a place with his girlfriend for $450 p/w. He leases the old PPR for $450 p/w, claims all available expenses and depreciation and sells it after 4 years, just as in the previous example. He claims the PPR CGT exemption for the entire amount as it is within the 6 year period so pays no CGT.
- For “year 1”, Smart Andy and John live identical lives. For years 2-5 however, Smart Andy enjoys the $4,140 p/a tax rebate from the depreciation claim totalling $16,560. With no CGT to pay, this is how much better off he ends up than John. And this is only utilising 4 of the 6 years available!
Other things to consider …
The Government is currently offering a range of incentives/savings for genuine “first time buyers”, including:
1/ Stamp Duty concessions. There are eligibility requirements and each state is different. Click the following link and then click on your State to find out more: https://business.gov.au/finance/taxation/stamp-duty/
2/ The First Homeloan Deposit Scheme. This Government scheme is open to the first 10,000 eligible applicants each financial year. It enables first time buyers to purchase their first home with as little as 5% deposit. Without such a scheme buyers would be unlikely to attain a bank loan, OR, would be subject to “mortgage insurance”. To find out more click here: https://www.nhfic.gov.au/what-we-do/support-to-buy-a-home/first-home-loan-deposit-scheme/.
3/ First Home Super Saver Scheme. From July 1st 2018, both concessional and non-concessional contributions that were made into Super (from 1st July 2017 onwards) can potentially be withdrawn from Super if they are to be used for purposes of a first home purchase. There are various rules/limits relating to this. To find out more click here: https://www.ato.gov.au/individuals/super/withdrawing-and-using-your-super/first-home-super-saver-scheme/.