When you decide to buy a new home, you might want to keep your existing home as a rental property rather than selling it. Turning your home into an investment property can be a great way to dip our toes into the world of real estate investing, but too often people do not structure things properly and miss out on the advantages available to them.

As mortgage advisors based in New Zealand, we are often asked to arrange the finance for upgrading home. We can also advice on how to structure the home loan – but always with proviso that talk to a professional tax account to ensure everything is done correctly.

Everyone’s situation is different so using a real-life example is an easy way to demonstrate how things work. This is an example for an Auckland family, Eric and Sarah. Before they met, Eric had already brought his home. Now they are looking to upgrade their home to a bigger house in a better location and keep their existing home as a rental property. Let’s get into the detail:

Buying a new house and turning your home into an investment property

Video Timeline

1. Turning your home into an investment property properly may save you thousands of dollars on tax - 00:48

2. Best structure when buying a new property and keeping your home as a rental - 05:39

1. Turning your home into an investment property properly may save you thousands of dollars on tax

The background

Eric is an IT professional and earns $100k of annual salary. His partner, Sarah, just graduated and recently secured a job in a daycare centre. The property that Eric owned worth approx. $680,000 which has a home loan of about $400,000. They find a property they like and wish to buy at the price of $1,100,000. They have cash available for the deposit, $200,000 from their savings and family gifting. So they need to borrow $900,000.

Their income and deposits are sufficient to service the total loan amount of $1,300,000, which means they can simply apply for the new lending of $900,000 to buy their new home. But in this case, we help the clients get the structure right and make sure they set up their home-turned-rental properly for tax efficiency, asset protection, the ability to pay off loan faster and other potential benefits.

Let’s crunch the numbers

If we treat the property investment like running a business, then we should crunch the numbers.

In the clients’ situation the property investment works like this:

Income
Rent @ 540 per week	$28,080

Direct Expenses		In total
Insurance	$1,000
Property management fee	0
Rates (council + water fixed charge)	$2,700
Repair & Maintenance	$500	$4,200

Profit before interest and tax	$23,880
Minimum loan amount to break-even	$999,163 (base on 2.39% interest rate)

By subtracting the total direct expenses from the annual rental income on the rental property, the profit before interest and tax is $23,880, which means if the clients don't have any home loans, no interest cost, then they need to pay income tax on the $23,880. But Eric does have interest cost accumulating on his loan of $400,000.

How much interest costs are deductible, so that the clients can minimise the tax obligation on the rental property and maximise the profit? A break-even loan and tax-saving analysis works like this:

To maximise the tax benefits, the interest costs should be, ideally, close to $23,880. Based on the current one-year rate of 2.39%, only when the loan amount reaches to approx. $1 million can the clients pay zero dollar on the tax.

Maximum loan can be borrowed	$680,000
Current loan Balance	$400,000
Additional loan can be borrowed	$280,000
Additional interest cost	$6,692
Tax saving per year (@ 33%)	$2,208

The reality is that the clients only have the loan of $400,000, which is far more below the $1 million. But the closer to this number, the less profit to pay tax on. The maximum loan amount they can borrow is the house’s market value ($680,000). So even though this number is still lower than the break-even loan amount, it's still better than the $400,000 because when they borrow extra $280,000, additional interest costs of $6,692 will occur. Based on the tax rate of 33%, the potential tax that Eric can save on his rental property is $2,200 every year as long as they keep the property. That’s a lot, right?

2. Best structure when buying a new property and keeping your home as a rental

Again, always with the proviso that talk to a professional tax account to ensure everything is done correctly, helping you save the tax on the rental property and other potential benefits. Let’s get into the detail:

LTC will purchase their existing home	$680,000
Funded by:
Bank A	$544,000
Bank B	$136,000

Eric as the vendor will receive sale proceeds from selling their existing home	$680,000
Less: Existing loan repayment	$400,000
Net sale proceeds	$280,000

Eric & Sarah will purchase a new home	$1,100,000
Funded by:
Sale proceeds - deposit	$280,000
Family gifting - deposit	$200,000
Bank B	$620,000

First, to maximise the tax benefits available the existing home needs to be sold and purchased by a new entity. In this case it was suggested they use a LTC (Look Through Company). Their existing home will be sold at the market value of $680,000. Bank A will lend 80% ($544,000) (at the time some banks still allow 80% of LVR for investment property loan). The remaining loan of $136,000 will be borrowed from another bank, bank B.

Second, Eric as a vendor will receive sale proceeds from selling his existing home at $680,000. After repaying $400,000 to the bank, he will have $280,000 cash in hands.

Third, they can use the net sale proceeds ($280,000) plus family gifting and their $200,000 saving as the deposit to buy their new home. So they will need to borrow $620,000 from bank B, and that's for the purpose of buying a new family home.

Get the loan structure right

Loan Structure	Borrower	Security	Security Value	LVR	Repayment
Bank A: $544,000	LTC	Existing Home	$680,000	80%	Interest Only
Bank B: $136,000	LTC	New Home			Interest Only
Bank B: $620,000	Eric & Sarah	New Home	$1,100,000	69%	Principal and Interest
$1,300,000

The final loan structure is the clients, under the name of LTC, will borrow 80% of the LVR ($544,000) from bank A. The loan repayment type will be interest only. The remaining of the purchase ($136,000), still under the LTC, will be borrowed from bank B, going for the interest-only as well. The clients will then borrow $620,000, less than 70% of LVR, under their joint names. As this is for family home purpose, we structure as principal and the interest. So, the total loan amount is still $1,300,000.

In a nutshell

It’s important to tailor your home loan to your circumstances, as one size doesn’t fit all. A right loan structure can help you in many ways. When converting your home into a rental property in this case, a proper loan structure helps the clients in the ways of:

Saving tax on the rental property – by maximizing the loan amount against the rental property, it helps increase the interest costs and then it can be deductible against rental income from the old home. As a result, we help the clients save thousands of dollars in tax when upgrading home.

Assets protection – when you have all your properties mortgaged at one bank, the bank can take collective security over all of them. In some worst-case scenarios, if you can’t afford to pay your mortgage, the bank could force the sale of your property to cover the debt you owe them. In this case, we help the clients split their loans across two banks and each bank only takes one property as the security, maximising the protection for their assets.

Paying off home loan faster – we structure the investment property loan as interest-only for two purposes. Firstly, the interest costs will be maxed out and the profit from the rental property will be minimized, saving tax on the renal property. Secondly, when the clients pay interest-only for their investment property loan, they will have more cash available to pay off their family home faster.

Prosperity Finance – here to help

There’s a lot to consider when purchasing a second home and keeping your first home as an investment property. If you’re contemplating upgrading home and liking the idea of converting your first home to a rental property, then you should get your loan structure right. Call us at 09 930 8999 for a chat with one of our mortgage advisors and we can go through this in more detail.

More Articles:

How can a good loan structure work well for you to save $900 on tax per year?

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

Things to watch when turning your family home into an investment property

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.