Offset in the name of the lower income earner

Once you have paid off your main residence you will probably want an offset account on one of your investment properties. This will be a useful place to store cash from rents and wages and also to save up a buffer for emergencies.

Where you have used the strategy of buying properties in sole names, some in the name of Spouse A and some in Spouse B, you can move money around to create tax savings.

You would generally want the cash in the name of the lower income earner as this spouse would generally be the one paying the least tax. Where there are several lenders involved (with that spouse) you would choose the lender with the highest rate as this will produce the highest return.

Money in an offset means less interest is incurred which means more income from the property.

Example

Homer is on the top marginal tax rate and his wife Marg has a taxable income of $0. They each own 2 rental properties. They have just paid off their home and old man Simpson has died and left them with $200,000 cash.

Where should they put it?

The answer, from a tax perspective, would be in an offset account attached to Marg’s loans.

Loan A is at 5% pa and Loan B at 5.5% pa. Both have offset accounts.

In this situation if $200,000 is deposited in:

Loan A the savings would be $10,000 per year. Marg would pay no tax on this

Loan B, the savings would be $11,000 per year. Marg would pay no tax on this.

There would no extra tax to pay as Marg’s income is $0 before this, and after depositing her income would be either $10,000 or $11,000 both of which are under the tax free threshold.

Let’s say Homer had 2 loans with each at 6% pa. If the $200,000 was deposited into either of Homer’s offset accounts the interest savings would be

$12,000 per year.

But as Homer’s interest decreases by $12,000 his income increases by this amount and because he is on the 47% tax rate 47% or $5,640 would be lost in extra tax.

Thus after considering tax the funds would be better placed into the offset account on Loan B belonging to Marg.

Keep in mind the legal consequences of ownership in different names too:

  • asset protection
  • estate planning on death
  • effect on spousal loan strategies

Perhaps a private loan agreement, even at nil%, can assist in legal planning.

This is also another reason to consider purchasing in sole names.

 

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

Don’t use Cash in Offset account to Invest

If cash is used to invest there is no interest to deduct.

However where money is taken from an offset account the interest on the loan that the offset is linked to will increase but the interest on this loan will still not directly be deductible.

There are 2 scenarios relating to this:

  1. Offset Main residence loan

If the offset account is attached to the main residence any removal of the cash will cause the non-deductible interest on the loan to increase. This interest will not be deductible because the loan is associated with a private purpose – the purchase of the main residence in this case.

E.g. $500,000 home loan with an offset attached containing $100,000 will mean interest is only charged of $400,000. If the $100,000 cash is used to invest, then the interest will be charged on the full $500,000. This will mean approx. $5000 per year in extra interest and lost deductions ($100,000 x 5%). For someone on the top tax rate this is like throwing $2,350 per year in the bin.

  1. Offset on an investment property loan

With an offset attached to an investment property the situation is similar – withdrawing of the cash will not be using borrowed money so there is no interest to claim. But indirectly there will be increased deductions because the interest on the investment loan will increase and the interest on this loan will be deductible against the investment property to which it relates.

E.g. $500,000 loan with a $100,000 offset balance. Loan relates to the purchase of 123 Smith St. $100,000 cash is withdrawn to buy 456 Jones St.

The interest on the loan for Smith St will increase by $5000 per year approx. The extra interest will be deductible against Smith St not Jones St.

Does it matter whether you use offset cash from an investment loan or borrow?

Immediately it won’t really matter. But longer term it will matter because if one property is sold there will be different consequences. Also there are advantages in borrowing as it will keep cash available for private expenses and will increase tax deductions if it is used for private expenses.

Also there will be different consequences if properties have different owners. $100,000 withdraw from an investment property offset in the name of Spouse A v $100,000 borrowed by A and on lent to B.

So think carefully before you go using offset account money.

Update – I just thought of something else relating to using cash in offset accounts and wrote something in a another thread on the issues of whether to use cash or to pay down a loan and reborrow

Unless you have available equity, and cannot borrow, you would only have 2 choices

  1. Use the cash to invest directly, or
  2. Use the cash to pay down the loan and reborrow to invest.

Which option you choose will depend on the situation.

If you plan to never move into the property relating to the existing loan again then paying it down may not give any extra advantages. Same tax consequence if you use cash or pay down and reborrow.

If there is a possibility that you may move into the new property at some point then you would want to reduce this loan size by using the cash in the offset account directly.

If there is a chance you could be selling one property at some stage then there will be different consequences as well.

If the properties will have different owners – .e.g. property A owned by you and property B owned by you and your spouse then there will be different tax consequences as your incomes will differ now and in the future.

 

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

 

Forgotten land Tax

I have met some people who have forgotten to claim land tax and/or thought they were exempt but were later caught out. Land tax can only be claimed in the year in which it relates to – not the year in which it was paid. ATO ID 2010/192 (now withdrawn, but law still current).

In some cases it will be too late to amend tax returns and these land tax costs will not be able to be claimed for prior years.

I had a call from an old friend who has a trust which owns 3 rental properties in NSW and has held them for about 10 years – yet they have never paid land tax and didn’t really know about it until I asked him how much he was paying.

The problem is when the property is sold the land tax clearance certificate will not be clear and he will have a large sum payable before settlement. Yet they will probably not be able to claim more than 2 years. As the trustee is liable this will also affect the distributions the trust has made and it will be messy to fix so there would be additional tax agent fees.

So if you haven’t done so already register for land tax and pay it as it is incurred.

Written by Terry Waugh, lawyer at Structuring Lawyers, www.structuringlawyers.com.au

keep All Receipts forever

By law you are only required to keep receipts for about 5 to 7 years. But for tax this is 7 years after you claim an expense.

You should always keep your receipts just in case. If you move out of the main residence and rent it at some stage then the expenses incurred when you were living there can be used to reduce the CGT payable. However you may not sell the property for another 50 years so you will need to keep receipts this long if you want to save tax.

When someone dies and their property is inherited by someone else the cost base of the deceased will often be the cost base of the property for the person that inherited the property. So expenses incurred when the deceased was alive and living there or renting the property out can be relevant to the tax of the person that inherited the property.

If there is a capital loss that is carried forward receipts relating to the loss should be kept from at least 5 years after it has been used up in full.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

Using Redraw to invest

Withdrawing from a loan is considered new borrowings for tax purposes. So the same principles apply as to all loans. It is generally the use the borrowed funds are put to that determines deductibility. The security of the loan does not matter for tax deductibility reasons.

The reason that using redraw is generally a ‘no no’ is that it usually results in a mixed purpose loan. If there are other monies which have been drawn down and used for other things then increasing one loan to buy a property will result in a mixed purpose loan. See my other tip on why not to mix loan purposes.

So unless your loan account balance is $0 it is best not to use redraw but to set up a new split before borrowing.

However where your loan is Interest Only it is possible to use redraw and to later split the loan into the relevant portions. If doing this you should not make any deposits to the loan account other than interest.

Ideally you would split before borrowing but some people buy property at short notice with no planning and in these cases it would be better to use redraw than to use cash to pay the deposit as a mixed loan can be unmixed later – see Tax Tip 44.

The main point is that using redraw will result in a mixed purpose loan – unless the redrawn amount is used for the same purpose as the underlying loan. So avoid redrawing if possible.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

Reimbursing yourself – Impossible

It is impossible to reimburse yourself with borrowed money after an asset has been paid for and claim the interest

Interest will only be deductible if borrowed funds are used to produce income.

Where people get into trouble with this sort of thing is when they don’t plan ahead, but may pay a 10% deposit using cash before they have the loans sorted out. Once a deposit is paid in cash it is paid. If you later borrow an equivalent amount from a loan increase and ‘pay yourself back’ the interest on this loan cannot be deductible because the interest does not relate to a loan used for the property.

So, before you pay any money for a property make sure you get the loans set up so that you can borrow to pay for that property.

On a $500,000 purchase a 10% deposit is $50,000.

A $50,000 cash payment, while you have non-deductible debt on the main residence, will result in about $2,500 per year in lost deductions ($50k x 5%). That is per year for the life of the loan. That could cost the average person $1000 per year out of their pocket – enough for a trip overseas each year.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

The Pleasures of CGT: 5 Reasons Why CGT is better than Income Tax

It is not often that you use the words ‘pleasure’ and ‘tax’ in the same sentence, but if you had a choice of income tax or Capital Gains Tax (CGT) it would be more pleasurable to pay CGT.

Here’s why:

1. CGT Tax is only payable at the end so greater compounding during the life of the investment

Example

2 investments of $100,000:

A. one returning 0% income with 10% capital gains, or

B. One returning 10% income with 0% capital gains.

Same overall return but different tax consequences.

 

In year 1

A will be worth $110,000 but no tax payable yet,

B will be worth $100,000 with income of $10,000 so up to nearly $5,000 lost in tax.

 

In year 2

A will be worth $121,000

B will be worth $105,00

Each returning the same 10% again.

If this continues the gap between A and B will widen each year.

 

2. Can be avoided completely on at least one and possibly 2 properties

The main residence exemption means one asset can be completely tax free. Careful planning can allow for 2 properties to be totally exempt for the whole ownership period.

3. The 50% CGT discount

Once the tax is payable most taxpayers will actually get a 50% reduction in the tax payable because of the 50% CGT discount. This applies for assets held longer than 12 months. It doesn’t apply to income received more than 12 months!

 

4. Personal expenses can reduce it

Move into an investment property and costs incurred while living in the property can be used to reduce the eventual CGT – potentially to nil. These are the 3rd element cost base expenses and include interest, rates, repairs, insurances etc. You can’t do this with income.

 

5. Time to Plan

CGT can be minimised by careful planning. This can involve timing strategies, bringing forward other expenses and other strategies some of which I have outlined at: Tax Tip 119: How to Reduce CGT on Investment Property (Part I)            https://propertychat.com.au/community/threads/tax-tip-119-how-to-reduce-cgt-on-investment-property-part-i.10681/

 

Written by Terry Waugh, solicitor at www.structuringlawyers.com.au

Borrowing to Pay Investment Expenses

Following on from the tip on debt recycling, one other variation is to borrow to pay both upfront and ongoing expenses. This can allow the recycling to happen even faster than normal.

Here we will talk about expenses other than interest (a topic for another day).

Upfront costs of a property that could be borrowed include:

  • Stamp duty
  • Government charges
  • Conveyancing Solicitor fees
  • Structuring Advice
  • Buyers agent fees

If you own an investment property there will be thousands of dollars in expenses to pay each year. These expenses may include:

  • rates
  • insurance
  • water
  • cleaning
  • repairs
  • biocycle sewerage maintenance
  • strata
  • etc.

Say these cost amount to $3,000 per year. If you pay these out of your pocket that is $3,000 that comes out of your non-deductible home loan or offset account attached to non-deductible loan (assuming it is not paid off). That means more non-deductible interest must be paid.

Instead of using cash to pay these expenses it may be possible to borrow to pay these expenses. If you borrowed $3,000 at 5% that is $150 in interest each year you must pay. But it is not $150 in additional interest as the $3,000 you would have used can go off the non-deductible home loan. This means the overall interest bill is the same.

The real benefit will be in the tax savings. If you are on the top tax rate the tax savings will be about $70 per year in the first year. That is $70 extra you can pay off your non-deductible home loan in year 1.

Not much you may think, but imagine you had 10 properties. Imagine the compounding effect over 2 or 3 years – or 30 years. Expenses also generally increase with inflation and as things wear out the repair costs become larger.

Some people take action to stop the property manager paying these expenses out of the rent. The more you pay yourself the more you can borrow to pay.

Also these expenses could be paid with a credit card which gives you points. More points means more rewards (just make sure the benefits outweigh the fees).

However there is a trap with credit cards – see a future tax tip on this (see Tax Tip 12). If using a credit card you must be careful not to mix expenses on it.

And some rental property managers will also allow their fees to be paid by the landlord instead of taking the fees from the rent.

Keep in mind that there can be other issues where the loan used to pay for the expenses is in a name other than the person who owns the property on which the expenses are paid – such as a spouse. See Tax Tip 79 for the situation where there are 2 spouses on the loan but the expenses relate to a property owned by one of them only. Where X is on the loan but the expenses relate to Y then a loan agreement would be needed.

Warning – This has all the marks of a ‘scheme’ with a dominant purpose of increasing tax deductions. Don’t implement this without professional tax advice. Members of the ATO have indicated they are looking into this strategy.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

Mixing Loans – Don’t do it!

It is common to see loan structuring mistakes with about 90% of the clients I see. One of the most common mistakes is ‘mixing’ loans. This occurs where one loan account has been used for more than 1 purpose and often happens when redraw is used on a loan, but can also happen when the one loan is increased.

An example:

Tom has an $80,000 loan with ANZ on a $100,000 property. He has paid the loan down to $60,000 but still has $20,000 available in redraw. The original loan was used to purchase his owner occupied property. Tom goes and buys an investment property and has the good sense not to use his cash but borrows the $20,000 from the original loan by redrawing it and using it as deposit.

Tom now has a mixed purpose loan. No real problem so far as the 2 purposes can be easily worked out and interest apportioned between them.

But problems can arise in the future.

Problem 1

If Tom’s loan is PI then he will be paying down the investment portion with every deposit he makes. The loan being one pool of debt he cannot segregate the repayments so they come off the non-deductible portion first. So every deposit he makes causes him to reduce his tax deductions which means he is losing money by paying more tax. He is essentially throwing money away.

Solution – split before using.

Problem 2

It will also be very difficult to calculate the portions of the loan. Each deposit made would come off both portions of the loan in relation to the percentage at the time of the portions at the date of deposit.

20/80 = 25%. So 25% of the loan relates to investment and 75% to private purposes. If the deposit into the loan is $100 then $25 must come off the investment portion and $75 off the private portion. Simple for the first deposit, but what if $328.77 in interest is charged for the month. 25% of this relates to the investment portion.

It would be very difficult to work out over a short period. But with some people this has gone on for many years and it would be very difficult to work out.

Solution – split before using.

Problem 3

Another problem is the offset account. Since it is one big loan Tom would be offsetting the investment portion too. Say Tom had $60,000 cash. He would still be paying interest on $20k yet 75% of this would be private interest and therefore not deductible.

Solution – split the loan before you use it. Tom could have had 2 splits of $20,000 and $60,000 he could set up the offset on the $60,000 loan and pay no non-deductible interest at all.

Problem 4

Sale Time. If Tom were to sell either property he would then need to do some readjusting. If he sold the main residence he would have to be careful about paying out the investment portion (topic of a future tax tip). Paying this out would be necessary because the loan is secured by the main residence. But this would cause Tom to lose deductions and also to have less cash available for his new main residence. Fortunately there may be a way around it in most cases. This issue would occur whether the loan was mixed or not. But it is only possible to rectify this if the loan is split before it is paid off.

However the ATO do allow a concession for these situations where the property relating to the loan is sold. See Tax Tip 55.

There are also issues with mixed loans where all portions of the loan relate to investments, albeit different investments. Tax Tip 20A An issue with mixed purpose loans where both portions are investment.

So what to do if you have mixed loans?

Fortunately the ATO allows mixed loans to be unmixed. Rolf says you cannot unscramble an egg, but the ATO allows you to notionally unscramble a mixed loan.

You must work out the relevant portions on a reasonable basis and the loan can then be split. Splitting means each loan portion will end up with a separate account number so they can be distinguished from each other.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

What is ‘Debt Recycling’?

‘Retirement’ can arrive sooner if you can pay off non-deductible debt faster.

Interest on a loan used to purchase the main residence is not deductible – some call this ‘bad debt’. While interest on loans used to purchase investment properties (shares, business etc. too) is deductible – so called ‘good debt’.

So wouldn’t it be good if you could change bad debt into good debt so you increase deductions to save tax and pay off loans faster?

Well, you can!!

As an example, most people would be paying PI on their home loan. The balance would be slowly decreasing. Some would be paying extra on the loan to pay it down faster. If you could reborrow this extra money paying off the loan and then invest it you would be charged around 4% pa in interest. This interest would then be deductible against the income from the investment. If the investment earns more than 4% pa then you would be in front and the extra money received could then be used to pay down the bad debt even faster.

Further reduction of bad debt would potentially mean more funds are available to be borrowed to invest. This in turn would potentially lead to more income to pay off the bad debt which could then be turned into good debt by borrowing again to invest.

If all goes well this could enable the bad debt to be paid off much quicker as the compounding takes effect.

This could be done with property, but most property would end up negative cash flow. But it could also be done with negative cash flow property and just hanging on for a few years and then selling and using the proceeds to pay down the bad debt and then re-borrowing.

You could speak to a licenced financial planner about using shares to do this. Shares are much easier to buy and sell and the costs in and out are very low.

Carefully planned, debt recycling can get you where you want to go sooner.

2018 update – these days owner occupier loans are at a cheaper interest rate than investment loans. Properly structured, debt recycling can allow owner occupied interest rates for investment loans, helping you to recycle a little bit faster still.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au