To assist investors in their decision making process, the following case study shows several allowances investors can claim including how to use the ATO's form 221D. We've put a copy of the ATO rental property guide for 2007 for free download. Click here to download the ATO page column 2 and 2nd paragraph showing you can tax deduct as soon as you purchase a property to be constructed for investment purposes.

A CASE STUDY OF BUILDING DEPRECIATION ALLOWANCES

Any residential dwelling which commenced construction in Australia after 17 July 1985, qualifies for an annual building allowance of at least 2.5% of the original construction cost. Lets assume the property is relatively new. Of its $420,000 purchase price, around 50% will be the actual cost of construction, the balance will be the land value. Of the $210,000 building cost, 2.5% of that figure can be taken as a tax deduction, that is $5,250 every year for forty years.

Purchase Price $420,000
Construction Cost $210,000
2.5% Depreciation $5,250 per annum

What we are in fact doing is writing off the cost of the building. Any residential property that is owned by an investor for rental purposes, and was built after July 1985, qualifies for that allowance. This factor makes newer properties significantly more attractive than properties that do not qualify for the depreciation allowance.

TAX FREE INCOME FROM RESIDENTIAL PROPERTY

Let us clearly understand this. A case study of one of the investment properties Graham and Andrea purchased had an income or rental of $350 per week or $18,200 per year. Of that $18,200 through the 2.5% building depreciation allowance, $5,250 or 21.15% of gross income, is TAX FREE.

Rent @ $350 per week $18,200 per annum
Building Depreciation Allowance 2.5% of $210,000 $5,250 per annum
% of Gross Income Tax free 28.84%

Back in 1985, two things happened, the building allowance was introduced, but so was capital gains tax. Capital gains tax takes away, the building allowance gives back. If you buy a property today for investment purposes that is older than twelve years, you pay capital gains tax if you sell it, but you do not get the trade-off benefit of the building allowance. That is a real distinction between older and newer property for investment purposes. Newer is just clearly better. That is $210,000 less taxable income Andrea and Graham will pay tax on over the life of the building, calculated at $5,250 per annum times forty years. At the highest marginal tax rate, this would be an approximate tax saving over the life of the building of over $105,000.

TAX SAVINGS FROM ADDITIONAL DEPRECIATION

The next major allowance or tax concession is depreciation on the fixtures and fittings in the dwelling, items such as the carpets, blinds, light fittings, the hot water system etc. In this case study they amount to a further deduction of $1,700. You are encouraged to contact firms such as Depro or visit their website.

BORROWING EXPENSES

Graham and Andrea then have the borrowing costs, that is the fees they paid the bank when they borrowed the money, loan application fees, stamp duty on mortgages, and mortgage insurance (if applicable). There are other statutory charges, lawyers search fees and sundry out of pocket expenses. On Graham and Andrea's purchase that amounted to a total of $3,300. That sum can be deducted for tax purposes over the term of the loan, or five years whichever is less. So if it is a three year fixed loan, which you renew, or re-finance at the end of the term, then you can deduct one third of all of those bank charges, in each of those three years, giving a deduction of $1,100 in the first twelve month period.

INTEREST TAX DEDUCTIONS

Graham and Andrea borrowed against existing assets when they purchased their first investment property. Initially it was their own home. Even though they borrowed on their home which is not an income earning property, the interest expense is deductible for income tax purposes as it is capital used to purchase other income producing property. It can be deducted against total income be it from investment property or salary.

Any expense that occurs in earning or generating income is deductible against total income for tax purposes and interest on borrowing makes up a major portion of those expenses.

As Graham and Andrea continued to escalate their real estate holdings they continued to borrow against existing assets including the growth equity they were achieving. All of which is deductible against income.

For the purposes of this case study Graham and Andrea borrowed 75% of existing assets which includes all properties acquired to that date, which represents 100% of the purchase cost of the newly acquired property, even though some of the borrowed amount is secured against their own home or other property.

THE FIRST TIME INVESTOR

It might be appropriate at this time to look at the first time investor and place him or her in Graham and Andrea’s shoes. Graham and Andrea purchased a home ten years ago for $110,000 plus costs. Today that home has increased in value to $320,000. They have a mortgage of $150,000 leaving equity of $170,000.

HOME POSITION TODAY

Value $320,000
Less Mortgage $150,000
Present Equity $170,000

They used that equity to borrow further funds for reinvestment. They established that they could without undue risk borrow 75% of the properties value or $240,000. They still had a mortgage of $150,000 providing $90,000 of new borrowings towards the down payment on further investments.

With $90,000 as a down payment they could borrow a further 75% of the value of any new acquisitions which works out to be $270,000, giving them a total of $360,000 less acquisition costs to spend on further purchases.

BORROW FOR FURTHER PROPERTY INVESTMENT

Current Value of Home $320,000
Increase Borrowings to 75% of Value $240,000
Less Current Home Loan ($150,000)
Further Borrowings Obtainable on New Acquisitions $90,000
Plus Loan on New Properties at 75% of Purchase Price $270,000
Funds Available for Further Purchase $360,000
Less Acquisition Costs $20,000
Available to use for another investment purchase is $340,000

The interest charges on the total borrowings of $360,000 would be a deduction against their total income, that is from all investments and salaries. At say 10% interest that would be a tax deduction for taxable income assessment of $36,000 per annum.

EXPERT ADVICE

Taxation issues in relation to property and property investment can be complicated and often require interpretation based on individual circumstances. We recommend you consult your Accountant or tax agent such as DKM Group for specific tax advice.

NEGATIVE GEARING NEEDS GROWTH

When the expenses from property exceed the income after all deductions including interest, the negative result can be applied to other income earned by the property investor to reduce total tax. Even though that income is not from property. It may be from salary, fixed interest investment, shares or other taxable sources.

This tax saving, when coupled with leveraged growth, can have dazzling results. Using leverage you can see how using borrowed funds multiplies the growth factor by incredible proportions.

Negative gearing produces a loss. Even though the after tax result is minimised it is still a loss and is only recaptured if the value of the investment grows over time.

Even minimal growth when leveraged can make a negatively geared property provide excellent results as we have seen in the case study of Graham and Andrea, where they turned the equity in their home into multi millions over the years. They continue to increase their property porfolio - houses buying houses.

But you must have growth. No amount of negative gearing will overcome the fact that you are subsidising the investment if the property does not grow in value.

What we are dealing with here is the further tax benefits of residential real estate investment which minimise the risks of negative gearing and make it stand out against other forms of investment.

Overlaying the normal interest deductions achieved from leveraged investment is the depreciation factor and how it applies to property.

In the case study we have used one of Graham and Andrea’s property purchases at $320,000 has an interest deduction on 100% of borrowings at 10% interest, which is $32,000 per annum.

Building Depreciation Allowance $ 5,250.00 per annum
Write Down on Loan Fees etc For First 3 years $ 1,100.00 per annum
Depreciation on Fittings & Furnishings $ 1,700.00 year one
Interest on Mortgage of $320,000 at 10% per annum $32,000.00 per annum
Property Expenses $ 3,900.00 per annum
Total Deductions $43,950.00 per annum

That gives us total deductions, i.e, the interest, the property expenses, the building allowance, the depreciation on the fixtures and fittings, and borrowing costs of $43,950 in a year.

We have received rental income of $18,200, the difference being $25,750, as the net loss on paper, even though we have not outlaid that amount. We have only actually outlaid $13,800 in cash.

Gross Rental Income Per Annum $18,200
Total Deductions Per Annum $43,950
Net Loss Per Annum ($25,750)
Non-Cash Deductions:
Building Depreciation $5,250
Depreciation on Fittings & Furnishings $1,700
Write Down on Loan Fees etc $1,100 $ 5,500
$13,800 p.a

It is the $25,750 net loss on paper that then reduces our other income for tax assessment. If we are earning a $70,000 taxable income, that income is reduced by $25,750, therefore reducing tax payable on that total $70,000 income. At the highest marginal tax rate (assume 35%) that is a tax credit or a tax saving of around $9,013 per year.

Gross Income $70,000
Net Loss From Property $25,750
Taxable Income $44,250
Tax $15,487
A further Tax Saving of $9,013 as a result of one investment property

THE TOTAL TAX SAVINGS

Keep in mind that we have outlaid cash of $13,800, but we have saved tax of $9,013, so the net cost of holding that property over a year is $4,787 or $92 per week.

Cash outlay $13,800 per annum
Tax saving $9,013 per annum
Net cost to hold $4,787 per annum
Net cost $ 92 per week

The after tax cost of $4,787 represents 7% of an income of $70,000 per annum. That represents a form of forced savings by accepting the commitment and obliging you to meet the shortfall. The property is expected to increase in value in excess of that amount so it is a suitable form of forced saving. Many regard saving 8% to 12% of gross income as a reasonable savings plan.

Carrying the cash outlay through the year however can be a burden even though you expect a large tax refund. You can elect not to carry that outlay.

HOW TO FUND THE CASH SHORTFALL

There is a provision in the tax act, under section 221D, whereby, as soon as you purchase the property, even before you have settled the purchase, that is, once you have exchanged the contract, you can arrange to reduce the tax being deducted from your salary. This involves completing a short questionnaire, asking details of your salary income, the rent that you expect to receive, the expenses that you expect to pay including the non cash deductions, and the net loss on the investment. Mail it to the tax office and usually within fourteen days you will receive a letter from the tax office, authorising the amount of tax currently being deducted from your PAYE income, to be reduced by the amount of $9,013 divided by the number of pay periods, in a year, whether it is fortnightly or weekly, effective immediately. Hand this letter to your employer who will immediately reduce your tax deductions by the appropriate amount.

So you only ever outlay the net amount over the course of the year. It is a simple process and avoids the fifteen months or so delay in recovering the tax benefits or refund from the Tax Office.

It is necessary to lodge a 221D annually, but it is very simple to do, and strongly recommended. There are some who prefer to carry the cost because they like to receive a large refund cheque at the end of the year, but keep in mind that by doing so you are lending money to the Federal Government interest free.

These are also essential principles when looking at serviceability of loans. The income that Graham and Andrea required to borrow the funds for this property was about $52,000 joint gross income, per year. Their annual gross income of around $70,000 allowed them to borrow the full amount in the case study of $360,000. The bank, in considering that loan, looked at a number of factors. They considered the rental income from the property, because it increased their income. They also took into account the fact that the interest on the loan and other expenses are tax deductible creating a tangible saving.

This is why you can borrow substantially more for investment purposes, than you can for home ownership.

There are other elements as well. Rental income, is important. But it is not the most important consideration. If rental were everything, then perhaps small, older factory units, where the net income returns are around 12% per annum might be better, but in our view depreciation, tax deductible expenses, growth potential and safety are much more important.

THE RETIREMENT ALTERNATIVES

Capital growth is an important consideration when borrowing to invest. By the time you retire, you will be more reluctant to take on the task of searching for property or approaching banks for loans. We all become more conservative, and income becomes very important. Our assets have to provide retirement income at that stage of life. As time passes, values rise, borrowings become a smaller proportion of total assets, and income can be turned into a positive cash-flow. Perhaps it is possible to live off that income. Another possibility is to sell one or more properties, and use the proceeds to reduce loans on the remaining properties. There are many levers you can pull to manage your situation through that period of time.

In the meantime if you are borrowing, especially when you are younger, to invest in property, you are probably subsidising income losses on the property. Even though those losses may be small and affordable, it is still costing you money. If capital growth does not occur, the outcome is not as rewarding so capital growth becomes a very important consideration. That point needs to be stressed because there are some who say negative gearing is the only important factor and saving tax is the purpose of the exercise. But negative gearing means you are subsidising the investment. You may pay a lot of tax but negative gearing in itself is not the main consideration. No amount of negative gearing, if the property does not grow in value will make a sound investment. Capital growth is the most important consideration.

KEEPING INVESTMENT WITHIN THE COMFORT ZONE

It is desirable to use available cash and income as effectively as possible to own property but within conservative constraints. A property bought today, if sold in the future, attracts capital gains tax, so immediate and ongoing benefits are essential. Taxable PAYE income can be immediately adjusted, by lodgement of a single 221D form. But even more importantly, whatever you do, ensure that it is at a comfortable level of commitment.

At the outset you must know how much you can borrow, based on actual income and resources. You can borrow more for investment purposes, than you can for home ownership. The average home loan available to Australians based on average joint household income (assuming no children and no other debts) of $60,000, is around $270,000. The same borrower, on the same income, purchasing income producing investment property could obtain a loan of around $320,000 over $50,000 more than for home purchase.

To give an indication of the amounts banks will lend for investment purposes, on a range of incomes we have provided some figures at the end of this page as a guide. They assume that there is no existing mortgage, or other major commitments. If so, then deduct the major commitment figure, and you will be able to calculate your approximate borrowing potential for investment purposes.

INTEREST ONLY V'S PRINCIPAL & INTEREST BORROWINGS

Whether to borrow money for a property investment purchase on an "interest only", or "principal and interest" basis would have to be one of the most common questions asked by property investor clients, and had to be addressed by Graham and Andrea when they decided to invest. The answer is a crystal clear "it depends".

Firstly, let us define our terms.

Interest Only

Offered by all major lenders, the interest only loan is the form of borrowing most often used by property investors.

It is a form of borrowing which is usually on fixed terms of between one and five years, at an interest rate fixed for the elected term, and on which only interest payments are made during the term of the loan. There is no reduction of principal or "paying off" of the loan along the way.

At the end of the term the principal is either re-financed for a further fixed term, or reverts to a principal and interest basis, or is repaid. A part repayment with the balance re-financed is another option.

If a fixed rate fixed term loan is wholly or partly repaid before expiration of the term, there may be early repayment penalties where the prevailing market rates are lower than your fixed rate. Generally, the longer the remaining term of the loan you are repaying, the higher the "break cost" penalties.

This is one reason why many people tend to prefer three year fixed loans as a middle ground option just in case a sale and or repayment of the loan needs to occur for any reason.

Only the interest component of any payments you make on an investment loan are tax deductible. Therefore on an interest only loan, the whole of the amount you pay each month is tax deductible.

This has obvious financial and cash-flow benefits simply by causing the property to require less of your income to hold it, and possibly more importantly, the fixed rate removes, at least for the fixed period, any surprises or discomfort that movements in interest rates can cause.

Principal and Interest

The classic use of Principal and Interest borrowings is the typical home loan.

When we borrow to buy a home, to some extent what we are doing is, rather than renting a home, we rent the money with which to buy one. And just like the cost of renting a house, the rent (interest) we pay on the money is not tax deductible and therefore very expensive.

With all these obvious burdens we generally embrace the notion that home loans should be reduced or "paid-of" as quickly as possible. And mostly we can only agree, although as we saw earlier we don’t necessarily need to totally pay off our home loan before we invest.

If and when you do reduce your home loan to nil it may be a good idea to ask your lender not to formally discharge the mortgage.

There are two advantages in doing this:

1) If you re-borrow in the future you may avoid further legal or registration costs if you borrow from the original lender.

2) The lender will continue to hold onto your Certificate of Title - that is, keep it in safe custody for you.

When principal and interest loans are used for property investment purposes different rules apply. The interest component is tax deductible, however, the proportion we pay to reduce or repay the principal is not.

With a typical twenty-five year term, the principal is progressively repaid over the term of the loan. In the early years most of our regular payments are in fact interest. In the later years the amount of principal repayment we are making increases as the amount of interest we are paying falls in line with the reducing principal.

Principal and Interest loans are most commonly offered with a variable interest rate. That is, the rate can rise and fall in line with financial markets which can be influenced by a myriad of factors from government monetary policy to exchange rates, to market competition.

MISCONCEPTIONS ABOUT INVESTMENT LOANS

There are many misconceptions about both types of loans as they relate to property investment. Some common ones include:

"Reducing the Principal increases equity"

Some see an advantage in reducing the principal as a form of increasing equity in the property. As a form of forced saving for those lacking financial discipline and who do not already have a home loan this could be appropriate. It does not actually create new equity, only increases in the value of the property can do that.

"How do we ever own it?"

If we borrow interest only for investment purposes it is because we are maximising use of our available income, to own as much property as we reasonably can, to receive the future benefit of capital growth. Sometimes it is not easy , but to some extent a shift in thinking away from the mind set of "paying-off" a home loan is required.

"What happens at the end of an interest only loan?"

These days when we borrow for a fixed term the loan is usually written as a longer twenty or twenty five year term but fixed for an initial period. Whilst it is usually simple to re-fix for a further period, if nothing is done at the end of the fixed period it automatically reverts to a variable rate basis.

In deciding whether to borrow on an interest only or principal and interest basis, what it all comes down to is a balance between financial discipline, temperament and depth of desire to build wealth in the most efficient manner.

If you are reasonably organised, efficient and ambitious then there is absolutely no doubt interest only loans were designed with you in mind.

If at the other end of the spectrum you are a worrier, less ambitious and disorganised then a Principal and Interest loan could be the way for you.

A slight exception to the rule could be if your home loan is totally paid off and you do not plan to upgrade with borrowings in the future, then borrowing for investment on a principal and interest basis probably does no major harm. Borrowing on a Principal and Interest basis for investment while still paying off a home loan is usually inappropriate.

Allocation of Disposable Income

If we have surplus or disposal income after other commitments and living expenses, we have to decide where is the most productive place to invest that surplus. Reducing the principal on a home loan because it is a non-deductable, inefficient form of borrowing would have to be the number one place to put surplus cash. Beyond that it is a matter of return on our investment. If you use that money to reduce principal on an investment loan, the interest will slowly reduce but so does the tax benefit. More importantly it does not create anything. You still own the same amount of property albeit with technically increasing equity, but that increased equity is your money, your surplus income, in the first place.

Other places to allocate that surplus income include borrowing more to own more property, or to acquire a second or subsequent property sooner, or alternatively accumulating that money in another form of investment which grows in value and choosing to reduce the loan by a lump sum at a point in the future. This could be at the end of a fixed term upon re-financing of the balance.

The Answer

It depends. Interest only is financially more efficient and budgetable, however if you cannot see past the idea that only principal and interest is within your comfort zone, then you are still better off doing that than not investing at all.

HOW MUCH CAN YOU BORROW ?

On a gross household income of $60,000, banks would lend around $310,000 for investment purposes. The following is a guide to borrowing ability at other levels of household income.

INCOME BORROWING LEVEL

$ 40,000 pa = $180,000 approx
$ 50,000 pa = $245,000 approx
$ 60,000 pa = $310,000 approx
$ 70,000 pa = $385,000 approx
$ 80,000 pa = $450,000 approx
$100,000 pa = $580,000 approx

These estimates are calculated on interest rates, tax rates and rents applicable at February 2008. If interest rates were higher, your borrowing capacity for investment purposes would be less. This does not necessarily mean you should wait for interest rates to be at their lowest point, which is actually impossible to know until after the fact anyway. It simply means if rates were higher you can borrow a little less at that time.

Not all banks use the same assessment criteria, and lending policies change frequently. Please consult with a Platinum Underwriter for borrowing capacity based on your particular situation and income levels.