Purchase costs of an investment property
In addition to having the required cash deposit or available equity, the following costs are standard for a property investment purchase:
Stamp Duty – levied by each state and territory government, stamp duty is payable on the full purchase price of a one-part contract (apartments, townhouses and houses) and only on the land component for house and land, 2 part, split contracts.
Legal Fees – a solicitor or conveyancer handles the legal review of the contracts and coordination and management of the exchange and settlement process.
Loan Costs – lenders charge application/establishment fees (can be negotiated or) for the loan and for stamp duty on the mortgage, their solicitor’s fees, a valuation fee, search fees and the cost of registering the mortgage.
Loan Mortgage Insurance – If the LVR is more than 80%, the lender will charge LMI. Lender’s Mortgage Insurance may be funded as part of the loan and may not require a cash outlay.
Pro-Rata adjustments– On settlement, you will have to allow for adjustments to the rates pro-rata for the year, (council rates, body corporate fees etc.,) In other words, pay your share of the annual costs.
Independent Building Inspection – it is advisable to engage the services of an independent building inspector to make sure that any defects are rectified before settlement takes place.
Quantity Surveyor’s Report – to claim the maximum deductions allowable for depreciation, it is essential to have a professionally prepared, itemized report that is handed to your accountant once for the life of the property.
Insurances – property investment like any other investment, carries some risk. Insuring your valuable asset will manage the risk via building, contents and landlord’s insurance. Lenders will require the property to be insured, naming the lender as the interested party, before advancing the borrowed funds.
As a guide, it is recommended to allow 4-5% of the purchase price for the costs of purchase in addition to the required deposit.
For example, to purchase a $500,000 property as a cash depositor, avoiding paying LMI, you would require:
DEPOSIT = $100,000
COSTS = $25,000
TOTAL = $125,000
To purchase the same property relying on the adequate available equity in other property, you would require:
DEPOSIT = NIL
COSTS = NIL
TOTAL = NO CASH OUTLAY
If the contract is a 2 part, house and land construction, stamp duty will be levied on the land component only, presenting the opportunity for a significant saving. However, there needs to be an allowance made to service the loan during the construction period.
The land is funded first, and then the house is built and paid for in stages.
One month after settlement of the land, interest will be payable on the outstanding balance.
Once construction starts, the building is paid for in stages, and so the loan balance progressively increases until fully drawn down after the final construction payment.
It’s like making ‘mini mortgage’ payments. The first full mortgage payment will be due one month after the loan is fully drawn down by the borrower.
When the reduced stamp duty applicable on land only is added up with the cost of servicing the loan during construction, it will be very similar to stamp duty payable on a single contract.
Both stamp duty and interest during construction are considered to be sunk costs and can be offset (claimed) against any capital gains tax liability when the property is eventually sold.
Ownership may be divided
The decision about who will own the property and in what proportion is typically based around individual incomes and marginal tax rates, to maximise rebates and to minimise tax obligations.
However, it’s also essential to consider the future. One party to the contract may be the lower-income earner now, but their future earning potential may be very different. Depending on the time horizon of the investment; they may need to sacrifice some rebates now to benefit from more significant returns in the future.
Exit strategies should also be considered. Capital Gains Tax obligations can be minimised by timing the exit in line with periods of lower-earning, planned absences from the workforce or retirement dates, and all may influence the ownership split nominated now.
Ownership splits of 99/1 to secure the vast majority of claims in the highest income earners name are now frowned upon by ASIC. They mandate that a borrower must stand to gain a ‘distinct benefit’ from being a co-borrower and 1% no longer amounts to that in their view.
To have a 1% interest and liability still means that borrower is jointly responsible for the entire debt and they must seek independent legal counsel before committing to such an arrangement. The accountancy fees for a 1% benefit is also unlikely to be justified by the small tax benefit.
The minimum is now a preferred 80/20 split.
In the case where a couple decides to have the property 100% in the higher income earners name, if the equity offered to secure the purchase is jointly owned, the other partner will be required to be a guarantor, and therefore is jointly responsible for the loan.
What one owns, the other does too, and what one owes, the other does also!
Deciding on the ownership split is a decision best made in conjunction with your accountant and mortgage broker.
A couple buying together will nominate whether they want to be:
- Joint tenants
Joint tenants hold the property equally between them and the income or loss from the property will also be split evenly. The property can only be disposed of wholly, not in parts and on death, ownership of the property passes to the surviving owner. Most committed couples would elect to have this setup.
2. Tenants in common
Shares in the property can be uneven (in line with the lending and regulator’s guidelines), and so the income and tax benefits are attributed according to percentage ownership. Tenants in Common can dispose of their share if they choose to. On death, the will of the deceased determines the outcome of the deceased’s share in the property.
ATO – Co-owners of a rental property
Equity is the value of an asset
minus any debt outstanding.
In the case of property:
In the example above the $500,000 property was purchased with a 20% deposit ($100,000). Over time the property has appreciated, and the debt has been paid down, giving the owner equity of $600,000 – $350,000 = $250,000.
Equity in this particular property is now 42% ($250,000 / $600,000)
If you have equity,
you have the opportunity to use some of that equity
as security to purchase
an investment property.
Equity is calculated on the current market value of your home (or investment property) minus what you owe the lender. As an investor, you can access up to 80% of your current property’s equity (without the need to take out Lenders Mortgage Insurance)
In the example above, the home was purchased for $500,000 with a 20% deposit ($100,000). Over time the property has appreciated and now has a market value of $600K (determined by a professional valuer’s report arranged by the lender) and the loan has been reduced to $350,000.There is now total equity of $250K.
However, the available or useable equity is calculated after retaining 20% of the market value ( $600K x 20% = $120K) and taking that away from the total equity $250,000 – $120,000 = $130,000
(Retaining 20% in the property avoids incurring LMI on the property offered as equity)
This $130,000 can then be used as security for another property.
Usually, the lender will then allow you to borrow 100% of the purchase price of the investment property plus your costs. This means there can be no cash outlay required.
Assuming once again, the homeowner would like to avoid LMI, they would be able to purchase property up to the value of approximately $500,000. (20% of $500K = $100K and this then leaves them $30K for costs)
However, given the variability of valuations, it would be wise to stay within their capacity and perhaps purchase a property for around $450,000 – allowing them to keep a buffer in reserve.
Borrowing capacity does not necessarily equal comfort range. The investor needs to decide what is sustainable and comfortable, long term, for them.
This can be verified by having the cash flow figures worked at different purchase prices and stress-tested for changes in interest rates, rent returns and vacancy rates etc