How To Invest Profitably In Real Estate. An Accountant s Perspective

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How To Invest Profitably In Real Estate An Accountant s Perspective A Special Report by DBA Accountants, Stirling, WA Invest in Real Estate or Not?

1 How To Invest Profitably In Real Estate An Accountant s Perspective A Special Report by DBA Accountants, Stirling, WA Invest in Real Estate or Not? How to Invest Profitably in Real Estate Buy Well Structure Correctly Borrow Correctly Hold for Long Enough Obtain the Right Advice Tax Deductions for Rental Properties Negative Gearing Only Works for Rich People Invest Jointly With Your Super Fund How Do DBA Accountants Help? Copyright 2016 DBA Accountants Disclaimer This Special Report is information, it is not advice. No action should be taken on it without first consulting DBA Accountants. The law referred to here is our understanding of the law at the time of writing.

2 Investing in real estate is a big, complex decision to make. The way to do it profitably is to make more right choices than wrong ones. And here is a catch straight away direct investment in real estate is for the long term and we do not control the future, so it is possible that today s right decision might be tomorrow s wrong one. There are ways investing in real estate that make money for you, and there are ways that do not. Read on Invest in Real Estate or Not? There are only five financial investments. 1. Cash 2. Real estate 3. Equities (eg, shares) 4. Businesses 5. Collectables, bullion, etc Over time, and over periods of different market sentiment, the degrees of capital risk and price volatility vary. It is possible to prove statistically that each one of them provides the greatest long-term return on investment simply by carefully selecting the start and end dates of the measurement period. All of which is irrelevant because the market conditions applicable then are not the conditions of today and are unlikely to recur tomorrow. Here, we limit our discussion to direct investment in real estate in Australia. We are discussing investment - buying and holding for income and capital growth. We are not discussing buying with the intention of re-selling for profit that is trading or speculation. How to Invest Profitably in Real Estate There are ways of investing in real estate that make money for you, and there are ways that do not. To invest profitably in real estate, you must do it right in five ways: 1. You must buy well and 2. You must structure the ownership correctly and 3. You must borrow correctly and 4. You must hold for long enough, and 5. You must obtain the right advice.

3 All this and have an eye to the future value and the rentability of the property. In any one situation and for any one person or couple, the perfect combination of these five requirements will be different. Buy Well Your eventual profit on the disposal of your investment is locked in when you buy. In lesson one, day one of Real Estate 101, you are taught there are only three considerations when buying real estate and they are: Location, location and location. That is wrong. There are three more for all real estate purchases: Price, price and price. When you buy real estate, you are buying either to live in, or you are buying as an investment, to be occupied by somebody else. The two types of purchase are completely different. The decision to purchase a home to live in has a high emotional content. The purchase of an investment has no emotional content at all, it is purely, 100% analytical; purely location and price. You are not going to live there, so you do not care what the kitchen is like. You only care about the cost of bringing it to rentable condition, the net rent it will earn and its future value. Structure Correctly What is the correct structure for purchasing real estate depends upon the specific circumstances of you, the buyer. It needs to be considered quite carefully and the cost of getting it wrong can be very high. The possibilities are: Buy in personal names Buy in a company Buy in a trust Buy in a superannuation fund The choice of which is best is a complex of taxation, asset protection and estate planning. We will guide you. Buying in personal names can be done as joint tenants or as tenants in common. The difference is: Tenants in common own a fixed percentage interest in a property and can deal separately with their separate interests. Ownership would be expressed as John Smith as to 50% and Mary Smith as to 50% as tenants in common or whatever the percentages were. John and Mary are able to deal with their ownership interests separately from each other.

4 Joint tenants, on the other hand, own the property jointly. Ownership is expressed as being John and Mary Smith or John Smith and Mary Smith jointly and severally. When one joint tenant dies, the remaining joint tenant(s) automatically inherit the interest of the deceased. Any dealing with the property must be carried out jointly. Buying in a company means that the property belongs to the company, not to the individuals behind of the company. In most situations, the property is safe from the creditors of the individuals. If the property is negatively geared (more later) the tax losses accumulate and carry forward in the company and are of no current benefit to the individuals. Buying in a trust provides similar security as buying in a company and losses accumulate in the same way. If the trust is a discretionary trust, profits and capital gains are able to be directed to selected beneficiaries a very valuable tax-planning tool. Assets, including real estate, are purchased in superannuation funds for two reasons: One is, the fund has the money and real estate investment fits the fund s investment strategy. The second is that the fund pays less income tax and capital gains tax. The lower rates of tax applicable to super funds mean that borrowing and negative gearing in a super fund is relatively unattractive. For more on the companies and trusts, see DBA Accountants Special Report, Thinking About Your Business Structure and for more on super funds, read our Report Thinking About Self-Managed Superannuation. They are on our website, but before taking action, speak with us. Borrow Correctly The ideal borrowing structure also requires discussion and advice. The DBA Accountants rule is: Keep It Simple. For starters, keep your own home loan separate from investment loans. This makes it simple to identify the tax-deductible interest from the non-deductible. Interest on money borrowed to acquire an income-producing asset will normally be a tax deduction. It does not matter what security is used for the loan, all that matters is the purpose to which the borrowed money is applied. The loan choices offered to you would probably be Principal and interest where each loan repayment contains an element of interest and an element of principal repayment, so that a set number of payments of a set amount will completely repay the loan over the contracted time. An excellent forced saving program.

5 Interest only where no repayment of principal is required for an agreed period. Preferred by investors as cash is preserved by not repaying principal and the whole of each loan payment is tax-deductible. Line of Credit or Equity Loan. Meaning: An overdraft facility secured against the value of your home. You spend and repay whatever you want, within the agreed limits. Your minimum monthly payment is the interest charged for the month. Good for people with strong spending discipline, a disaster for loose spenders. Low documentation loans ( Lo doc ). The lender accepts the borrower s assurance as to their income and ability to repay. For accepting a greater risk, lo doc lenders charge more in interest and (especially) up-front fees. Popular with the ATO. It is a simple matter for their auditors to check that the income claimed in the loan application is the same as the income disclosed in that person s tax return. There are usually only fairly small differences in interest rates and bank fees between the major lenders and between different mortgage products from the same lender, given the same security for the loan. Hold For Long Enough Real estate investment is for the long term, defined as being around 10 years, or more. However, life might not follow your plan for it and you may need to sell. If this happens, the team at DBA Accountants will help you answer these vitally important questions: 1. Must you sell? Are there other strategies available? 2. If you must sell, are there advantageous ways of structuring the transaction? 3. Has the property appreciated enough in value to recover your buying and selling costs? 4. What are the taxation consequences? 5. What is the ripple effect on your lifetime financial plan and your estate planning? Obtain the Right Advice There are complex legal, estate planning and taxation consequences to a decision to buy real estate and borrow the money to do it. Advice is needed and that advice needs to be independent and intended purely for your benefit. Anything else is a sales pitch, aimed at causing you to take a certain action that will benefit the sales person. Make sure you are making your decision, not theirs.

6 The way to sort the sales pitch from pure advice is to ask how that person gets paid. If they are paid only if you adopt a certain course of action, their very clear bias is to make the sale, regardless of the consequences for you. Here, we include those who claim to be salaried, not on a commission their bonus and promotion depends on them meeting their sales targets. Talk to us at DBA Accountants before you take action. Come in for a dose of objective common sense from your accountant who wants to see you growing your wealth, not throwing it away. We have been around for a while and we have seen it before. We provide impartial advice in return for our fee. We have no product to sell and no commission to earn and any inducements offered are directed to our client. We do not seek headlines and fame. Our bias is towards helping you become a wealthy, long-term client of our firm. Tax Deductions for Rental Properties Any dollar spent on an investment property has a taxation consequence. It will be: Tax-deductible in the year of spending as a repair or running cost, or cost related to tenancy. Deductible over time as depreciation of a chattel. Deductible over time as part of the building or an addition to it. Part of the cost of acquiring the property. To be tax deductible, expenses must be actually incurred and must be directly connected with earning income as a landlord. If an expense has joint investment and personal purposes, only the investment-related portion may be claimed as a tax deduction. Receipts are essential to prove an expense was incurred. A list of the most common tax deductions is available on our website at Fact Sheets and Checklists. Go to Here is a short list of mistakes identified by the ATO, where landlords claim tax deductions when they should not: claiming rental deductions for properties not genuinely available for rent; incorrectly claiming deductions for properties only available for rent part of the year such as a holiday home; incorrectly claiming structural improvement costs as repairs when they are capital works deductions, such as re-modelling a bathroom or building a pergola;

7 overstating deduction claims for the interest on loans taken out to purchase, renovate or maintain a rental property. Goods and Services Tax needs to be considered. Investors in commercial and short-stay residential property may need to register for GST and claim back the GST component in expenses paid. With residential property, no GST registration is required. You claim the GST-inclusive amount of each expense If you are in any doubt about how the ATO might view your property expenses or GST obligations, talk to us. Negative Gearing Only Works for Rich People Negative gearing means the investor has borrowed such that interest payments and other expenses exceed income from the property and as a result, it earns a negative profit. It looks clever in times of rising markets, multiplying the gains. But gearing works in downtrends as well, multiplying losses. This inconvenient truth will be ignored in any get rich through real estate shark-fest seminar. Our taxation system allows a tax deduction for negative gearing and rich people on high rates of tax receive a greater benefit from those deductions. In effect, rich people receive a greater subsidy from the Commonwealth for investing in this way and by doing so, increase the stock of housing available. This is how it works: Leaving aside Medicare and other levies because they are not taxes, the richest taxpayers are in the highest tax bracket and they pay 45c tax for each dollar of taxable income above $180,000. The lowest tax bracket is $18,201 to $37,000 taxable income and in that bracket, income tax is 19c in the dollar. Tax rates will change but this lesson will not. A negative gearing loss of $20,000 produces these tax savings Rich taxpayer $20,000 x 45% = $9,000 Not rich taxpayer $20,000 x 19% = $3,800 An investor hopes their investment will increase in value by more than the cost of holding it. If the holding cost is the amount of the after-income tax negative gearing loss, how much does this investment need to go up in value for the investor to break even? Rich investor $20,000 - $9,000 = $11,000 Not rich $20,000 - $3,800 = $16,200 (50% more than needed by the rich investor)

8 When the investment property is sold, Capital Gains Tax applies. Here again rich investors are favoured by the system. Our advice is: Negative gearing is very definitely not the panacea the property spruikers claim it to be. Talk to us before you do it. Invest Jointly With Your Super Fund Not many people realise they are able to make an investment jointly with their super fund and by doing so, significantly advance their real estate accumulation in a very, very taxeffective manner. For this strategy to work, it is essential you have advice from an adviser with experience in self-managed superannuation. The laws governing self-managed super are complex and mistakes are expensive. The Strategy is this: You and your superannuation fund purchase a rental property as tenants in common. The super fund puts in its own cash. You borrow your share of the purchase price (say, against the equity in your home). Income and expenses of the property are shared between you and your super fund in proportion to your ownership. Result: Your super fund has no debt (gearing) but you are negatively geared, with attendant tax advantages. The super fund pays less tax than you do on its rent income and capital gains, or no tax, if it is in pension phase. How Do DBA Accountants Help? DBA Accountants, of Mt Lawley, WA, are old hands in the provision of wealth-building advice and we remind you at this point of the Sleep Test: If you will not be able to sleep at night with what you are thinking of doing, do not do it. The Sleep Test is the ultimate test and it applies in all areas of Life, not just investment and real estate. At DBA Accountants we are not mere tax return preparers. Our service helps our clients increase their wealth. To do this, we will do anything within our power that is legal, moral and ethical.

9 We are specialists in Business, Tax, Self-Managed Superannuation, Estate Planning. There is a wide range of useful information on our website, Disclaimer This Special Report is information, it is not advice. No action should be taken on it without first consulting DBA Accountants. The law referred to here is our understanding of the law at the time of writing.

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