HOW BUYING BEN & RENEE'S DREAM HOME 5 YEARS BEFORE THEY NEEDED IT SAVED THEM $345,351 AND HELP
When I think about my family home, the saying, “don’t put off until tomorrow what you can do today” comes to mind. The purchase of our family home is hands down, the best financial decision I’ve ever made – but in today’s housing market, it’s not easy.
As a kid, I remember running around my family house with my sister and those memories are still with me today.
So when Ben and Renee came to me asking how they could afford to live in a leafy suburb near the good schools across the bridge. I understood the importance of making those memories and the impact they had on me when I was growing up. However, three things weighed on my mind; affordability, will they be able to sustain strenuous careers and meet the demands of family life and support a very large mortgage.
It was Ben and Renee's goal not to have a significant mortgage hanging over their heads, instead having the option of debt working for them. They were planning on saving and investing in shares for the next five years, so they could afford to buy in the leafy suburb by the beach.
So with some brainstorming Beth & I, came up with a strategy to help Ben & Renee attain their dream home using our five step game plan.
Our advice: instead of waiting five years to buy their home, we advised them to buy their dream home now and to pull on all the financial levers available to pay down the home loan as fast as possible.
The Benefits of Buying a “Family Home” as an Investor
Housing affordability, rising house prices and rents in Australia attract lots of debate and media coverage.
In particular, it seems these days you can’t watch or read the news without reports of Melbourne’s booming property prices. Melbourne’s suburbs continue to experience significant growth and this is across both ends of the property market spectrum.
The latest figures released by REIV revealed Melbourne’s Metro median house price rose 3.2 percent to a record high $740,000 in the last quarter (ending September 2016) and Inner Melbourne’s median house price rose 4.2 percent to a record high $1,336,500. Depending on whether you’re buying or selling, it can either be a potentially lucrative or incredibly stressful time looking for something to buy that you can afford.
With these figures in mind Ben and Renee took the plunge to buy their family home initially as an investment property. The tax concessions afforded to investors would greatly help them pay off their debt and help them move into their family home sooner.
So imagine a scenario where you’ve made an investment purchase on the property you plan on making your family home one day in the future.
Strategy 1: Make negative gearing work for you
Tax reform was a big issue during the recent federal election campaign. Specifically, there were calls for restrictions to the negative gearing policy and a cut to the Capital Gains Tax (CGT) discount. However, since the Coalition secured power, federal Treasurer Scott Morrison has flagged that any existing tax concessions won’t be changed at all. This is good news to Australia’s 2 million landlords. So my advice would be: use these current regulations and tax concessions to your advantage.
Simply defined, negative gearing means that the interest (and other expenses like rates, management fees and maintenance) you are paying on your investment property is more than the income (rent) generated. As a result, your investment is making a loss, for which the government provides generous tax concessions.
If you negatively gear, you’re able to claim your loss to reduce your income tax. So for example, if your property reports a loss of say, $15,000 and your annual income is $100,000; your taxable income is then reduced to $85,000.
Strategy 2: Get down with depreciation
We all know that if you own a car for work, you’re able to claim depreciation on your vehicle against your assessable income. It’s the same with your investment property. Claiming depreciation on your property can potentially save you thousands.
As a property investor, you can claim depreciation on the cost of the building itself (Building Allowance), such as concrete and brickwork and the items within the property, such as ovens, dishwashers, carpet and blinds, etc. (known as depreciation on Plant and Equipment). However, it’s important to note that in order to claim depreciation on both, your property needs to have been built or renovated after July 1985.
Strategy 3: Rent it out
The next important factor to take into consideration is the rental yield you can expect on your investment. It’s typically between 3 to 5%. Some suburbs in Melbourne do better than others, however, with some properties yielding more than 6% annually.
The Benefits of Buying Today
Right, so we’ve looked at the possible advantages of buying your dream home as an investment. So let’s take it one step further and look into the ways you can use this to help pay off your future home.
Strategy 4: Lock it in !
There’s probably no greater endorsement for this home buying strategy than being able to lock in a price five years earlier.
House price growth in Inner Melbourne has increased about 7.1% per year over the past decade and in 2016, so far Melbourne has seen a growth of about 13%.
Had they followed their original investment strategy and waited those five years to buy, I don’t think they could have afforded to buy the home they live in today.
Strategy 5: Defer the pain of paying for capital gain
Capital Gains Tax (CGT) is the tax applied when you sell an investment and make a capital gain or profit. Family homes are exempt; however because the property was initially an investment the CGT exemption does apply for the period it was rented.
So, this is the real kicker in our home purchase strategy. Usually, if you purchase an investment outside of your family home, you’re liable to pay capital gains tax. Even with the Capital Gains Tax (CGT) discount, you could still end up having to pay thousands.
But imagine you’ve purchased your family home as an investment. If you plan on living there for let’s say 20+ years (which Ben & Renee's family intends to do), then you’re effectively deferring that payment for the time you live there. But say you never plan on selling, you will never be obligated to pay CGT. If you it will be prorated over the time frame you rented it.
So how is it possible to save $345,351?
OK, so we’ve gone through the five different strategies that can contribute to you buying your dream home sooner than you think. But how does it all work?
What I’m about to detail is exactly the strategy we employed to secure our client their dream family home. I’ll illustrate the process using a hypothetical Melbourne property – you will need to plug in the figures which fit your circumstances.
So for this scenario, let’s imagine you’re looking to buy a property for $1.25 million. This isn’t so far fetched given the median house price in Inner Melbourne now sits at $1,336,500. In fact, as of September this year, 104 suburbs across Melbourne recorded property sales of more than $1 million.
Step 1: Organise your deposit and loan
For the purchase of their new family home, they had built up equity in their existing home. This allowed for a 20% deposit, after which they borrowed the remaining 80%.
This allowed them to borrow the entire cost of the home including the fees. Some of you may be thinking, “Isn’t that a risky move?” It definitely has the potential to be risky if you don’t have a clear plan on how you’ll pay it back, but we’ll come back to that shortly.
But back to our scenario. On a purchase of a $1.25 million property, if you were to borrow 100% of the purchase price after taking into account the fees, you’d be looking at a total loan of $1,320,023. Now imagine taking out a loan at today’s interest rate of about 4 – 5%. The worst case scenario is that you’ll be repaying a massive $52,800 in annual interest payments to maintain the loan. That is an astronomical amount of money. Let’s see what you can do to offset that.
Step 2: Rent it out
Here we have a scenario where you’ve purchased your family home for $1.25 million but you’re likely facing some hefty interest repayments. One way to dramatically reduce this: we turn to Strategy 3 and rent out your house.
Let’s say you’ve bought in a suburb like Yarraville, which according to Core Data, yielded about 3.44% rental return. The likely annual rent on a house in Yarraville would be about $43,000
With this rental income helping to pay off the interest, your annual shortfall reduces from $52,800 to $9,800. That’s a huge reduction of about 81.43% to keep your house each year.
Step 3: Take advantage of tax deductions
Here I would use Strategy 1: making negative gearing work for you. From our scenario, we’ve made a loss of $9,800 as the rent doesn’t cover the loan interest repayments. We can claim this loss to minimise our income tax.
We can also use to our advantage Strategy 2: depreciation. So I’d recommend getting a depreciation schedule (which is 100% tax deductible) to see where you can make further tax savings.
In the case of this house, an extension was built in 2011 and because we had a depreciation schedule, that allowed Ben & Renee's to reduce their taxable income by a further $8,000 at tax time.
When they combined the tax deductions of negative gearing and depreciation, they were able to reduce their taxable income by $17,800, which was no small feat. Say your income attracts a 37% tax rate. You can potentially get a $9,300 refund from the ATO.
So how do these deductions help to minimise the costs of keeping their $1.25 million dream home. They had a shortfall of $9,800, but being able to reduce their tax debt through negative gearing and depreciation could potentially pocket them $9,300. The amount of keeping the house now becomes $500 per annum.
If you think about that amount – $500* – from our original possible monthly loan repayment of $52,800 – you can save a staggering amount of money.
*Note: I have not included maintenance or fee\tax expenses in the cost to hold – this varies too much between properties to calculate.
Step 4: “Lock it in,” – Locking in your home in today’s prices
As I mentioned earlier, the past 10 years has seen an average house price growth of about 7% per annum. Even if we’re conservative in that figure, we can expect house growth to be at least around 5%.
This growth – whilst obviously a positive thing – can make it difficult for you to afford your dream home the longer you leave it.
So if you’re buying your 1.25 million dollar property which grows about 5% per annum, it’ll be worth in the vicinity of $1,595,351 in five years’ time. That’s potentially an additional $345,351 you could save if you buy your family home five years before you need it.
Step 5: Come up with and stick to plan to pay off the loan
Not wanting a huge mortgage hanging over their head whilst having a family, we structured the family house hold budget to pump as much as possible into paying off the house over five years.
Of course, your ability to do this will depend on each families personal circumstances, especially whether the extra financial commitment would put too much of a dint into your family’s quality of life.
However, I believe the short term sacrifice is worth it. They were able to pay an extra $30,000 a year over five years, after which, they shaved off $150,000 off the loan.