Most of us know that there are some very good tax benefits to holding a rental property. We buy a property that will give us a good rental return and hope (as history has shown us) that the property goes up in value. And in doing so look to increase our wealth.
The Rent that is received on the property is assessed as income and any expenses that are incurred in holding and maintaining the property are included as deductions, If the rent is more than the expenses then we may have extra tax to pay, however when the expenses are more it creates a tax loss and we are able to offset this off our income and reduce our tax.
One particular scenario I see quite a bit is where a client has purchased a property, usually some time ago, lived in the property and paid off a substantial amount of the mortgage. They then find a property that they love – it might be their dream home. Because they have significant equity in the original property they use the equity to purchase the new home to live in and rent out the original home.
The problem with this scenario is that their new home has 100% debt. 100% Bad debt!
We often to refer as debt as “good debt” and “bad debt”. Good Debt is debt that is incurred in growing your wealth, such as a rental property loan or a loan for your business and are mostly tax deductible. “Bad Debt” is debt that is incurred for lifestyle purposes such as your home, that new jet ski or credit card debt. The things that you can buy with these are loans are sometimes fun but they won’t increase your wealth and they are generally not tax deductible.
I had a new client in the other day wanting to see how she could reduce her tax. She had a property that she had purchased some time ago that she had fully paid off, it had been her home. About 12 months ago she bought another property with her partner which has 100% debt. They both moved into the new home, and she rented her existing property out. So, after preparing her tax return she had a hefty tax bill of nearly $9,000 because she had very little to claim back against the rent she was receiving. After discussing several scenarios and her objectives, in this situation she decided that they should move back into the original property and rent out the new one. Because of the high level of debt on the new home, the expenses are quite a bit more than the rent and she can offset this against her other income. So, she now is in a position to receive a tax refund of a few thousand dollars instead of that hefty bill.
She just had to go home and talk her partner into it 😊
The best thing to do before making any major investment decision is to seek professional advice on how best to structure it from a taxation, asset protection and wealth accumulation perspective, to maximise your wealth potential.
This communication has been prepared on a general advice basis only. The information has not been prepared to take into account your specific objectives, needs and financial situation. The information may not be appropriate to your individual needs and you should seek advice from your financial advisor/ accountant before making any investment decisions
Michele Purvis is an advisor with over 30 years experience working in the accounting and financial services industry helping clients to define and create their wealth.