Living off Capital
Perhaps we should start with the quote from our esteemed accountant:
Originally Posted by DaleGG
It is when you borrow money from the banks and use those funds to enjoy a lifestyle without paying tax.
Because the money is borrowed, it is not classed as income and hence the tax free status of it.
However, the trap is that your debt level is rising each year and you must be personally comfortable with this notion, and, find a banking source that will be comfortable with you doing so.
Obviously, you need to have a reasonable level of assets to be able to do this.
Dale
It has been my observation that the vast majority of very wealthy Australians live off capital. Example is that a certain Mr. Packer is purported to declare a taxable income of just $25K per annum.
Now I think it is reasonable to assume that such people are getting their living expenses from somewhere . . . hence funding out of a capital base.
Dale of course is absolutely correct when he says that one would need a reasonable level of assets to do this.
The choices in life revolve around the fact that you either work to produce an income, or you control assets that produce the income for you. The balance between self and assets as regards income accrual is the measure of how close one is to financial independence.
FINANCIAL INDEPENDENCE then is perhaps the point where your assets are producing sufficient income to cover your lifestyle needs.
STEP 1:
Acquire the assets!!
Yes it seems obvious and is this not the path that most of us are on?
STEP 2:
Structure the income you wish to receive.
There are many choices here:
a) Day job
b) Wrapping
c) Positively cash flowed property
d) Dividends from shares
e) Interest on cash
f) Other types of income
Generally most of these form part of a taxable income stream.
My view has always been that we are educated from the earliest days to work hard to earn money. We are encouraged to hop onto a treadmill and further encouraged to keep running . . . literally until we drop. (See working beyond retirement 65 years – Costello)
Actually, this is brilliant for the country because someone has to pay for parliamentary pensions and other very necessary infrastructure. This is termed the tax system.
So, no argument from me . . . however some people prefer to contribute to the system in a slightly different way:
Own properties = Housing other families. (Govt. certainly needs all the help it can get as there are apparently in excess of 250,000 families on the Govt. housing waiting list.)
Buy shares = capitalizing companies, which provides employment.
LIVING OFF CAPITAL
What does this entail?
In the first instance one certainly needs to come to terms with the fact that “NET EQUITY” is NOT debt!
So if one purchases a property valued at $400,000 and borrows (80%) $320,000,
YOU ARE NOT IN DEBT . . . you are in
NET CREDIT to the tune of $80,000.
Note that your LVR is 80% (I will refer to this later)
Now also note that you might just as well have deposited the $80.000 in a bank and you would still be in credit for $80,000.
(NO LEVERAGE and NO MISCONCEPTION of DEBT.)
Let us further assume that the property is Negatively Geared:
Some people regard this as bad debt, because it is thus “costing” you money.
‘Repayment’ of the loan is NOT a debt, it is merely an expense!!
Looking beyond this one might suggest that the property achieves average capital growth of at least 5% per annum. If you do not believe this is possible, then perhaps property is not for you. (The average is 7% for the major Australian cities – past 20 years: ref REIA)
$400,000 (LVR 80%) at 5% p.a. = $20,000 capital increase.
So,
IF the property has increased in value and is revalued at $420,000, then draw down the extra equity up to the same LVR. (80%)
Calculation:
$420,000 X 80% = $336,000 less original loan of $320,000.
Net capital = $16,000.
Please note that the cost of the extra loan at say 7% = $1,120 p.a.
So Capital of $16,000 – $1,120 = $14,880 NET after expenses.
Lets be prudent and conservative and reinvest $4,880 into shares / cash offset / pay down debt . . . leaving a balance of $10,000 of passive income. (One step along the path to financial independence.)
Simply stated then:
If your requirement for financial independence is $50,000 net of tax, then you need to control 5 properties on the same basis as appears above.
Paradigm shift: $2,000,000 of asset and $1,600,000 of loans. (Note: Also 80% LVR)
(Q) So you are not sleeping because of the $1.6 mil of loans??
You are
not in debt!! you are still in 20%
Credit.
Some questions:
(Q) Serviceability issues: What happens if I cannot get further loans to duplicate the process?
(A) Please read up and gain a
FULL understanding of cashbond structure.
(Q) What happens if the properties do not average a 5% p.a. average growth?
(A) Please read up and gain a
FULL understanding of “Rental Reality”.
(A) Do NOT spend in excess of whatever the properties have appreciated.
(Q) How does this work in the long term??
(A) Lets consider a 5 year time period:
$2,000,000 of property growing at 5% p.a. for 5 years = $2,552,557-59 at the end of the 5th year. Equity gain of $552,557-59.
Assuming you have drawn down the full 80% of the gain: = $442,046
Cost of repayments at 7% pa = $30,943 X 5 years = $154,716
$442,046 –$154,716 = $287,330 / 5 years
Therefore passive income per year = $57,466 p.a.
Note that the excess in year 1 of $4,880 after expenses has grown to an excess of $7,446 at year five. Reinvesting this amount each year in shares also at 5% p.a. becomes substantial over time!
COST OF MAINTANING THE STRUCTURE:
Associated costs include the cost of the cashbond (Difference of the interest charged to borrow the money against the return on the annuity); Possible LMI; extra interest cost if using LO DOC / NO DOC loans and also affordability of Negative Gearing cash flow.
All these extra costs can be paid out of the annual passive income, but will of course reduce the net passive income for financial independence.
The solution is obviously to go further into
“net credit” so as to reach the desired level of passive income required for Financial Independence.
The income is of a capital nature, so as pointed out by Dale GG is NOT taxable.
The passive income of $50,000 net of tax is produced by being “in credit” to the tune of $400,000.
Producing the same level of income from net rentals at a 30% tax rate would require at a 4.5% rental return, a gross income amount of $82,094 / 4.5% = Total net assets of $1,824,317!! (4.56 X)
No wonder the smiling rich are getting richer!
Regards,
Steve
