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Updated 1 March 2012.
A popular way for people to get into the rental market comes when they want to ‘upgrade’ to a new property but want to hold onto the old one. Most people look at the old property and say "Sell", but a few enterprising people look at the old property and say "Rent out". When people make the decision to rent out the old property and use the equity to purchase a new place of residence, advice should be sought on the taxation consequences.
Here are some items to think about should you find yourself in this situation. Please note that it is general advice and you should seek advice about your own situation.
Interest
When you move out of your property, the loan used to purchase that property is now tax deductible. This is great because it will reduce the tax on the rental income and perhaps increase your refund should the property be overall negatively geared.
There are some traps though. In some cases, some people may have taken advantage of redraw facilities to buy a car or go on a holiday. If so, the interest on your loans is now partially deductible. For example, if you bought a house for $150,000 and then bought a car for $50,000, then you move out, your loan is now 75% deductible for the rest of its existence.
In other cases, the banks recommended lines of credit to customers to ‘pay off that house sooner’. This is bad. To calculate the deductible portion of the loan, every deposit and private withdrawal requires a calculation to carry the deductible proportion of the loan forward to find out the deduction for interest. In a worst case scenario, the entire interest could be considered non-deductible under the principles established in Domjan’s case.
If there is a possibility that you will consider renting out a property, an interest only loan with an offset account is the best course of action. The loan to purchase the property will remain at its original level, and you can put your surplus funds into the offset account to reduce the interest you are charged. When you are ready to move, you can use the balance of the offset account as a deposit on the new home and it will not affect the deductibility of the original loan.
If you find yourself with a polluted loan, you can refinance the deductible portion out (TR 2000/2) so you can focus on paying off the non-deductible debt first (which costs more because it is not giving you any tax breaks) before attacking the deductible debt.
Depreciation?
Depreciation is a great non-cash deduction, but is it worth getting a schedule when you move out of a property? This is a difficult question to answer because it depends on how long you lived in the property, how old the property is and what is actually in the property. This is where speaking to your accountant or a quantity surveyor to ask their advice is worthwhile. If you lived in a property what was built in the 60s and lived there for about 8 years, it may not be worth getting a schedule. If you moved into a newly built property and lived there for three years and renovated a bit, it would be worth getting a schedule.
Repairs
Some people may be tempted to touch up and repair properties before they move on. Wait until you move out. As soon as the property is held or used by someone for income-producing purposes, a deduction for repairs is available even if the cost is to repair items that were worn down while the house was held privately.
I would point out here that the ATO has a different definition of the word ‘repair’ than most of us would have, and there have been a lot of rulings on this subject. When it doubt, speak to your tax agent about whether something is considered a repair.
Capital Gains
A special rule applies when you move out if a property for the first time (that was not used to provude income previously) after the 20/8/1996 and commence to use it as a rental. The cost base of the property is reset to the market value of the property at the time you move out (s 118-192) so you will need to get a valuer to give you the value of the property at that time should you ever sell it, or a real estate agent that can compare your sale value to 3 recent property sales. Please note that this reset only occurs once during your time of owning the property, and it occurs at the time the property is first used to produce income (ie first rented out). If the house was purchased before this date, the cost base is still what it was previously but the taxable gain is apportioned by the days it was held privately vs rented out.
Another interesting rule is the 6 year leave of absence rule. One you leave the property, you can choose to have it remain your place of residence (making the house tax free on sale) for another six years if you continue to rent it out, or indefinitely should you just let it sit. The only proviso is that another house cannot be considered to be your place of residence during this time. You do not need to make a final decision on which house will be your place of residence until you sell one of them. You can move back within the 6 years, make the house your place of residence again, move out and a brand new 6 year leave of absence rule can apply.
This rule is useful for people who move out to rent or move back home to their parents as they are not living anywhere that they own so they can keep the extension going. It is also useful for people going overseas and intend to rent out their house while they are away.
Also note that you should capital gains apply to selling your house, if the house was purchased after 20/8/1991, you can add to the cost base of the property expenses you have not claimed as a deduction, even expenses that were incurred when the house was used privately. You cannot use costs incurred to increase the cost base if the costs were incurred before the house was reset to market value.
Of course capital gains does not apply to properties purchased before 20/9/1985 unless they are substantially renovated.
A typical misconception held by many investors is that if you move into a rental prior to selling it, it will be tax free on sale. This is incorrect. Once a house is not covered by a principal place of residence exemption, there will always be a capital gains tax liability if the property is sold.
Other strategies?
Because the loan is usually quite low on the old property and the new house will be fully geared with non-deductible debt, some people get around to asking how to transfer the non-deductible debt into deductible debt. There are some options, but remember that any of these carries the risk of Part IVA – if you implement any of these strategies to obtain a tax benefit, the tax benefit is lost and additional interest and penalties apply.
Selling to a spouse.
You can actually sell a part of the property to your spouse, and borrow up to 100% of the value of the portion that you are buying. For example, if Jim and Jane own a house worth $300k and are moving to a new house and renting out the old one, Jim can borrow $150k to buy Jane’s share, and the loan to borrow the $150k is fully tax deductible. The $150k that Jane receives can be used to purchase the new property. There may be stamp duty to pay, depending on the state you live in. There is an interpretative decision to back this up.
Selling to a unit trust
This is a risky strategy as Part IVA has a strong argument. Basically, you get a loan for the value of the old house plus stamp duty, set up a unit trust, buy the units in the unit trust for the same value and have the unit trust buy the old property off you. The loan proceeds go into the unit trust, and then back out to the home owner. The proceeds can then be used to purchase the new house, and the interest on the loan used to buy the units in the unit trust is then fully deductible.
This is a superior strategy than the spouse strategy but the ATO would argue tax avoidance. A person utilising this strategy would have to present the counter factual that if the old house was sold at market, and a new house was purchased in the unit trust, the tax and cash position would be no different (and indeed that is a way of using this strategy in a safer fashion), except this way there is no need to pay a real estate agent to sell the old house so there are some cash savings.
If you have any questions about this article, or want to ask some questions that weren’t addressed here, feel free to email me.
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