When people upgrade their family home and keep their old home as an investment property, they can generally borrow the majority of the purchase cost if they have sufficient equity in their existing property portfolio. However, the interest on the new loan is not tax deductible against rental income from the old home as it fails the purpose of the loan test (i.e. the loan is for purchasing a new home, not for an investment property). As a result, the new investment property (i.e. the old home) generates big taxable profits.

In this week’s blog, we use a case study to discuss how a right loan structure could help you save ten thousands of dollars in tax each year when upgrading home.

Incorrectly converting home to investment property might cost you extra $7k a year

Video Timeline

1. When Luke and Jane upgrade home and keep their old home as an investment property, they could lose $7,789. -- 00:57

2. How could Luke and Jane save $7,789 annually by using right structure? -- 02:25

1. When Luke and Jane upgrade home and keep their old home as an investment property, they could lose $7,789

Luke and Jane, a married couple, plan to upgrade their family home. They can borrow the entire purchase costs of $930,000 for their new home as they have enough equity.

When the clients approached us, we analysed their situation and found that:

If they simply borrow $930,000 for the purchase of their new home, the interest on the $930,000 new debt won’t be tax deductible. Their old home is debt free with market value of $820,000 and rent appraisal of $600 per week (equivalent to $31,200 per year). Once they rent it out they expect to receive a rental income of $31,200 per year with their total operating expenses (insurance, rates, property management cost etc.) at $7,596 per year, producing a taxable profit of $23,604. At the 33% tax rate, they would have to pay $7,789 in tax.

2. How could Luke and Jane save $7,789 annually by using right structure? 

If they first ‘sell’ their old home to a separate entity (company or trust), then that entity would be able to borrow 100% of the purchase price. As the purchase of the loan is to purchase an investment property, all of the interest costs on that loan are therefore tax deductible against the rental income – heavily reducing their taxable profit. In some situations where the investment property loan is large, your “look-through company” (LTC) is likely to incur a tax loss therefore they may qualify for tax refund. 

The difference between these structures is tens of thousands of dollars in tax payments. 

Had they moved the old home to a new structure and borrowed the money therein, the debt would have been tax deductible:

• The rent income is the same - $31,200 per year.
• Total operating expenses are the same - $7,596 per year.
• However under this structure, $41,000 of interest cost (on the $820,000 loan at 5% interest rate) is deductible, bringing the total deductions to $48,596 ($7,596 + $41,000).
• They incur a taxable loss of $17,396 ($31,200 - $48,596). With the correct structure, Luke and Jane could save $7,789. 

So, if you’re thinking about upgrading family home, we highly recommend you ‘sell’ your old home to a separate entity, then that entity would be able to borrow 100% of the purchase price. All of the interest costs on that loan are therefore tax deductible against the rental income. Above all, talk to your professional tax accountant to make a personalized plan.

Prosperity Finance - here to help

Prosperity Finance looks at property investment strategically, empowering you to make the best long-term, informed decisions. We are professional mortgage brokers and are here to help. Give us a call today on 09 930 8999.

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Disclaimer: The content in this article are provided for general situation purpose only. To the extent that any such information, opinions, views and recommendations constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised financial advice. We therefore recommend that you seek advice from your adviser before taking any action.