Warning on buying property with large amount of debt

We are both 47 years old, in full time employment, earning $160,000 and $130,000, respectively, and with two son's aged 8 and 9. Our superannuation funds currently hold $250,000 and $200,000, respectively, plus we have about $75,000 in shares outside of super. We have 10 properties in NSW and Queensland and in the UK, including our Sydney home with a $400,000 mortgage completely offset. Our total Australian property assets are valued at $4.5 million, with principal and interest mortgages of $1.9 million. Our UK properties contain conservatively $500,000 in equity and are positively geared, producing $1,750 per month. We submit withholding variations to the Australian Taxation Office, so that we are paying only three per cent of my salary this financial year. We AirBnB our house out when we go on our 2-4 week summer vacation to at least ensure the vacation is cost neutral. We would like to be in a position to choose to comfortably retire somewhere between 55-60 years old, with an annual income of $75,000, possibly in Malaysia, or Spain etc, to make our money go further. Are we on track to achieve this goal? What investment strategy would you recommend next in our situation? Stick with investing in property or diversify using managed funds, bonds etc?   D.S.

I would cautiously say that you appear to have sufficient assets, at current low interest rates, to meet your goals.

However, it concerns me that, in recent years it has been fashionable, in certain quarters, to speculate by buying multiple properties with large amounts of debt.

You need accessible cash reserves to run 10 properties worth well over $5 million at a time of falling prices.Credit:Rob Homer

Providing you can afford the loans, this can be a successful strategy when total values are rising because any growth increases the capital you have invested, while the amount of debt remains fixed.

However, the process is reversed when property prices fall as the drop in total value comes off your capital, while the debt again remains fixed. So, whether or not a large borrower goes bankrupt depends on the extent of the price fall.

Curiously, as prices fall, the amount of capital invested then becomes of secondary concern, the primary trigger being the Loan to Value Ratio, or LVR, that your lenders are prepared to accept as prices fall.

‘Distressed sale’

For other readers, banks have to put aside a certain amount of capital for each residential mortgage, depending on the LVR and a number of other factors, such as the existence of mortgage insurance, owner occupied vs investment etc. But the LVR thresholds set by the Australian Prudential Regulation Authority are 60, 80, 90 and 100 per cent.

As prices fall and the LVR rises to each threshold, a bank must set aside increased capital, which is why, at some stage, it would demand that the borrower provide more capital (to reduce the LVR), or sell the property. The catch is that such a “distressed sale” usually occurs in a falling market.

You don’t really give enough information to take a considered view of your situation but I’m not convinced that you have the accessible cash reserve to run 10 properties worth well over $5 million at a time of falling prices.

Right now, central banks have backed off their desire to raise interest rates, so I suspect that falls in property prices may ease off for a while, although I don’t think they are anywhere near their lows.

However, if inflation rises, possibly due to a wage push, then central banks around the world would be faced with the dilemma of watching their currency debase or raising interest rates and causing a recession. Historically, responsible governments have chose the latter option.

My husband and I are becoming empty nesters and would like to modify our house to create a self-contained two bedroom flat out of about one third of the house. What are the tax implications? We would expect to rent the flat for about $300-$400 a week, with power and water included. We owe about $600,000 on the mortgage and will need to purchase a washing machine, fridge etc. Are there capital gains tax issues we need to be aware of?   G.O.

The rent you receive would be taxable each year, reduced by any costs you undertake to rent the property, such as advertising and accounting fees, depreciation, power, gas and water costs, plus a proportion (by area i.e. one third) of the mortgage interest.

It is best to use an accountant and you may also find it useful to have separate meters installed, if you find your tenants are adding disproportionately to your utility bills.

When you start to rent the flat, you should get the house valued as it will be free of capital gains tax until that point, assuming you have never earned income from your main residence before.

When the house is eventually sold, CGT will be levied on the profits made from the time you started to rent in proportion to the amount of floor space rented (one third in your case) and the amount of time it has been rented.

For example, you may sell in 20 years' time but may only have rented it for 10 years. In such a case, the capital gain since 2019 will be reduced to one third (because of the floor space rented) and then again by half (it being only rented half the time) before you halve it again (thanks to the standard 50 per cent discount, if it still exists). That amount will be added to your income in the year the property was sold. In fact, if the house is jointly owned, halve that net amount again to and add the result (about 4.2 per cent of the total gain in this example) to each spouse’s taxable income.

We are 85 year old self-funded retirees with a combined income of $68,277, which includes $15,544 in franking credits. We have never had an age pension but do have the Commonwealth Seniors Health card. We sell a few shares each year to live comfortably and pay down some capital gains tax on our more than 20-year-old shares. We receive $10,528 net from a rental unit purchased in 1991, now valued at $450,000 with a capital gains tax liability of $350,000. My husband receives $3,850 annually from a pension fund balance of $45,000. If Labor wins government, should we sell the unit and then qualify by being under the pension assets test threshold? We may need the government support for future nursing home requirements. E.B.

I suspect you must be receiving over $54,000 a year in dividends, implying a share portfolio of some $1.3 million, or thereabouts.

If so, then selling the rental unit and paying the capital gains tax would not lower your assets below the $387,500 level necessary to get a full pension under the assets test, nor even the upper threshold of $848,000, which would be necessary for you to get a part pension.

You could have valid reasons to sell the property if, for example, there is no one you wish to bequeath it to and you don’t want to live through an extended property downturn, or you are fed up with bad tenants, or you have received an above-market-offer, etc.

However, I wouldn’t sell for fear of a new government.

As it stands, I estimate you would be using some 70 per cent of your franking credits to reduce your tax to zero and so, assuming the Labor policy not to refund unused franking credits is introduced, your income would not drop by the full amount of franking credits, which is some $7,770 each (assuming joint holdings), whereas the unused franking credits amount to about $2,380 each.

Note that aged-care fees set by the government are not affected whether or not you receive an age pension.

As a final piece of advice, work hard to keep your husband on his perch because, if he lets go, you would earn too much to retain the Seniors Health Card.

If you have a question for George Cochrane, send it to Personal Investment, PO Box 3001, Tamarama, NSW, 2026. Help lines: Australian Financial Complaints Authority, 1800 931 678; Centrelink pensions 13 23 00. All letters answered.

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