Living off Equity... Tax Effectively!
Thanks for the warm welcome. I don't specifically recall reading any of Steve Navra's posts as yet, but shall look him up sometime soon for my curiousity...
redwing: Yes, I have spent quite a lot of time writing posts in various forums in recent years. I've been a little quiet lately, but am delighted to have come onboard as a registered member of this forum. It has quickly become obvious there are so many genuinely helpful members here who are willing to share a lot of useful information... It's an honour to be a part of such a great community and I will do my best to be a positive contributor periodically as time permits. I'm learning heaps myself too, so it's all good!
Anyway, back to the topic at hand...
Lacasa, here are my responses to your questions:
Q. Do you calculate the cost of holding the properties, ie property managers fees, maintenance, insurance, rates, land tax etc.
A. Yes, although personally I like to simplify how I look at the expenses by just considering that I have a little less rent available when I do my calculations. Let's look at the individual expenses you've mentioned, along with one way of simplifying things. I'll start by using some hypothetical percentages (it should make sense why I do this as you continue to read):
8% of rent = Property Management Fees
4% of rent = Insurance
9% of rent = Council Rates
9% of rent = Repairs/Mantenance
2% of rent = Land Tax
It's not that difficult to work out these percentages based on your current portfolio (either property by property, or across your whole portfolio). For example, if you know your Council Rates are $400 per quarter ($1,600 p.a.) on a property that rents for $340 per week ($17,680 p.a.) then you can calculate $1,600 / $17,680 * 100 and this would be about 9%. To determine Repairs/Maintenance, you could either make an educated guess or alternately base it on the amounts you've claimed in previous financial years (perhaps allowing a small increase to cover inflation). As for Land Tax, for future purchases it's worth seeing if you can reduce this by spreading ownership of your properties amongst different entities, e.g. You, Your Spouse (if applicable), Companies/Trusts (check your State laws to find out more).
Looking at the example percentages given above, the total of the expenses adds up to 32% of the rental income. Let's call it one-third to be conservative (this allows for a small vacany factor). Here's the point -
If I can still see my LOE strategy working if I only include two-thirds of the rental income for the relevant period, then this gives me enough peace of mind that I don't need to worry about the details. It's as easy as that!
I'll admit this is quite a different way of looking at things, especially for anyone who is used to keeping a strict budget and trying to track each and every dollar being spent. Now-a-days, I'm much happier to simplify things whenever possible and feel very comfortable just knowing that I'm heading in the right direction. I actually used to be one of the most analytical people I knew, but having seen what works for me and what doesn't, I realised that the areas I was spending the most time analysing often weren't bringing in the money. It made a lot of sense to narrow my focus down to the key areas that gave me positive results. As my experience continued to grow over time, I've realised
it's just as much about "dropping what doesn't work" as it is about "doing what does work". OK, back to topic again...
Q. Additionally, what about the income tax on rental income? By my calculations, which by the way are very rough, I think I would get about $55 000 net in income from the rents (my actual gross rental income is $70 000 so a little less than you figures)
A. Rental income is definitely taxable, but remember that the interest on the debt used to acquire your rental properties should be tax deductable (along with any interest on borrowed money used to pay for your investment property expenses, if applicable). On top of this, the amount you pay for your IP's Council Rates, Insurance, Property Manager's fees, Repairs/Maintenance and Land Tax (plus allowances for depreciation) should give you even more tax deductions. I don't think you'll have a tax problem at all!! (OK, I admit it'll be a different story if you decide to sell one or more of your properties and realise a large capital gain - but at least CGT can be deferred virtually indefinitely, if you choose not to sell!)
Q. I though LOE was tax free since it comes from borrowed funds? I’m missing something badly here?
A. It's true that you don't pay tax on the actual borrowed funds, but it depends on the purpose (i.e. usage) of those borrowed funds as to whether or not the loan can be considered tax deductable. I've read about how others live off equity by borrowing additional funds to spend on their lifestyle. I don't believe this approach is as efficient as it could be, as there's no rational way you could ever justify this as a tax deductable purpose.
My preference is to fund my lifestyle by using as much of my rental income as I need to live comfortably. This way, when I do borrow extra funds, it's usually for only one of four possible reasons:
- To pay my investment property expenses (e.g. Rates, Insurance, Repairs/Maintenance, Land Tax, Adding Value, Advertising).
- To use for more investing.
- To pay taxation bills.
- To make up the shortfall between the rent I didn't spend on living expenses and my loan repayments.
Interest payable on funds borrowed for #1, #2 & #3 should be tax deductable by anyone's interpretation of our taxation system. Interest on #4 may, or may not, be deductable, depending on how you've structured things. Assuming that you take the conservative approach and don't claim a tax deduction for the interest on #4, I'd call this a small price to pay for the benefits of having a working LOE strategy in place.
Let's also consider what you could do if you decide to occasionally sell one of your properties (I'm personally willing to sell one property per financial year as a general rule of thumb, although part of my strategy means that if I sell one property then I must commit to at least another two so that I keep my asset base growing). Once an investment property is sold, couldn't you use the sales proceeds as follows:
- Firstly - Pay out the loan relevant to this property.
- Secondly - Pay out as much of the loan used for #4 as possible, therefore minimising your non-deductable debt with the equity you release each time you sell a property.
Then, when you lodge your tax return a year or so later and suddenly realise you have a big CGT bill that you "forgot" to budget for, couldn't you borrow extra to pay this and then claim the interest on this loan as a tax deduction (as per #3 above)? I'm not an accountant (and I'm not suggesting this particular approach, because you're not supposed to be implementing a strategy with the primary motivation of reducing the ATO's revenue), but I believe within the scope of our tax laws (along with the help of a good accountant), this may be justified from time to time and could help your LOE strategy become extremely tax effective!
Having said all that, allow me to conclude by saying this:
You don't
need to have all the answers right from the day you start living off equity.
I started LOE back in 2002 quite accidentally, just by thinking that I'd release some equity to have a year off work so I could decide what I wanted to do next. Before the year was up, something "clicked" for me and I realised that I actually didn't need to go back to work! Specifically, it became clear that I could still continue to grow my wealth through a mix of passive & active investing, underpinned by living off equity for the foreseeable future.
Over the last 5 years, I've gradually been refining things each financial year to make my LOE strategy more and more efficient based on my circumstances. Sometimes, waiting until you have the "perfect" strategy (does such a thing even exist?!) and all the answers to your questions might mean you end up stuck on the side-lines whilst someone else with very little knowledge is making more money, just because they are "in the game" so to speak.
Don't get me wrong, it's important to have some idea of what you are getting yourself into, in particular knowing how to manage the risks as best you can. All that I am saying is don't let too much self-education be an excuse to keep you at the starting line, waiting forever for the perfect moment to begin. Having read hundreds of books, attended plenty of seminars and spent countless hours pondering everything, I believe I can honestly say that I've learnt the most by giving things a go myself and then learning along the way. Once you get going, then continuing your self-education becomes much more relevant and is definitely one of the best things you can do to keep yourself on track and improving.
Anyway, I'd better stop at that or this post is going to get way too huge!
I hope this has been of some value...
Jason.
