Different Implementations of the LOE

The subject of LOE has been raised more than usual lately....

LOE is risky – this is because of the volatility of IP growth, eg Japan has experienced 50% fall is IP values over the last 15 years, after a significant bubble. However, LOE will work if the risks are reduced significantly – a lot depends on your SANF.

LOE is defined as a concept that entails borrowing ever-increasing amounts to live on secured against assets like IPs & shares. Another attribute of LOE is since you don’t have an income you don’t pay income tax.

A couple of the problems with using LOE are –
  • What if IP growth doesn’t happen?
  • What if the banks won’t lend any more money for non-income producing investments ie living expenses?
There are many ways of implementing the LOE concept. Some of the LOE strategies that are in use by posters here –
  1. Pure LOE, relies solely on growth in IPs, with no risk mitigation – this is for the extremely wealthy & confident
  2. LOE with risks mitigated using a share-trading fund to produce income – this is not strictly LOE since it relies on income.
  3. Continually value-add/renovate to create equity, and draw down a small proportion of this equity to live on. This assumes you don’t currently want to retire - there are significant tax savings with this type of work.
  4. Have a huge amount of undrawn equity guaranteed to last 20+ years taking even after into account interest rate rises.
  5. Use LOE with different asset classes to reduce the volatility in growth.
  6. Have some c/f +ve income to cover living essentials, and use LOE for luxuries if/when growth occurs.
  7. Diversify into shares with a margin loan, receive the dividends, but capitalise some/all the interest using a margin loan.
  8. Have lots of c/f –ve growth IP, continue working to fund the shortfall, but borrow against IP for living expenses. This is similar to capitalising interest.
  9. Buy 7 houses over 7 years & draw down equity on each one successively after the 7th year - no risk mitigation.
Assuming all goes well, a significant benefit of LOE is that it gets safer as time passes – rents increase, dividends increase, asset growth continues, equity gets locked in and debts increase at less than the rate of growth. And as a result of the last points, LVR decreases. The reduction in the LVR allows more borrowing next year to use as living expenses.

Another upside of using LOE is that it can be converted to a low risk strategy at any point in time e.g. if the banks stop lending money, or LVR gets to 80% after a period of no or –ve growth. Sell some assets and invest the profits in lower risk, higher yielding assets eg LPTs. The significant downsides of this are that it’s likely asset prices will be low when you need to sell; CGT will be payable and transaction costs will also eat into the gains....... and you’ll start paying income tax on the income produced. Timing will play a big part in optimally converting a proportion of growth assets into a low risk strategy whilst still incorporating LOE.

I use a combination of options 4,5,6&7. I have significant amounts of undrawn equity (therefore a low LVR), I diversify into shares & LPTs which are counter cyclical to IP, and I have enough +c/f for basic living if growth fails or the banks won’t lend. I pay small amounts of income tax, but compared to the asset growth & income it less than 4%. I have inthe past doen the odd reno.

Diversification
The diversification makes it likely that one of the asset classes is growing at any one time, so I can draw down based on the lower LVR. The stable +ve c/f ensures that I’ll have enough for food & bill regardless of any of the above worst case scenarios. I don’t consider that tenants will stop paying rent, all the blue chip companies stop paying dividends, and the banks stop lending money to be a worst case scenario – it’s likely there’ll be far more serious things to worry about than money if all of those occur at the same time.

Safer as Time Passes
As mentioned above, LOE gets safer as time passes. This is because the low volatility returns increase - ie income via rents & dividends rise faster than expenses - so portfolios become more c/f +ve. The high volatility returns (ie growth) will on average make the real difference to reducing risk, but unfortunately not in the short term (<10 yrs).
Additionally, with purchasing LPTs/quality shares you’ve got a margin lender to borrow from (or capitalise interest) if the banks won’t lend against IP.

Low risk LOE as an optimal early retirement strategy
  • The much publicised Pure LOE is v. risky with relatively small amounts of equity & high LVRs. Waiting until the LVRs are lower or equity is much higher will reduce risk, but takes an extra property cycle or two for this to happen.
  • The traditional approach of waiting until rents provide enough +ve c/f is v. slow.
The alternative as suggested above is to divest a proportion of IP assets (pay CGT) and invest the proceeds into counter-cyclical higher-yielding assets. This gives +ve c/f and diversification, and also gives a lower overall LVR. This is a lower risk early retirement strategy using LOE enhanced with +ve c/f, and is tax effective.
 
Safer as time goes on

I am interested in LOE, and wish I had the equity to do it!
However I would query that it gets safer as time goes on.
If it is working well, (high capital growth, plenty of spare equity and not too much inflation), but if these factors are not present, and your LVR is effectively increasing, or if even if your LVR stays about stable, then LOE could get worse. If you do find yourself with declining equity and wait to long to liquidate, you may find you have little equity left over after CGT.
Seems more like it gets safer if it goes well and you have plenty of equity as a buffer. How would it look after a sustained high interest rate period or price downturn (these things could easily occur together). Not necessarily safer.
It may look that way coming off the back of Australias biggest ever property boom. Would have been hard to convince people of this in 1997 though!
The proposed solution to this would likely be to borrow heavily beforehand, perhaps to invest in stocks or another asset class. But if property prices do drop significantly and then you need to sell (eg. to meet a margin call), then you could find you owe more than the value of the property.
Just some risks to keep in mind.
Seems like once you have an adequate buffer to cover this risk, LOE is a bit like getting a bank loan in the old days.
You can only afford to do it if you don't need to.
Not putting down the idea totally: the fact you don't pay tax on drawings is very appealing if you have a very large equity/income position.
Also though, the interest on borrowings to fund lifestyle would not be deductable, would they? As time goes on, these borrowings would account for more and more of the proportion of the loans interest and as rents rose eventually you would start paying tax on rent, which could not be offset by neg gearing on interest (as most of it was for non-income producing purposes)
 
That's exactly how I see it Keith. I think the diversification into counter cyclical and high income assets reduces risk and improves performance. And also reduces the impact of the increasing interest bill of continual equity redraws.

Good post:D

MJK
 
zenq - I think you are focusing on the debt rather than the complete picture. This is an issue that bothered me for some time and rightly so, but with a structured plan you can control the debt and in some cases over time the debt can be reduced simply by having the right structure/plan. Try focusing on the LVR or equity that seems to help me.

Have a look at the link below, the numbers are taken from a real life example (not me). It illustrates the difference between no additional investments into income producing investment (in this case MF) and investing an addition 50% of liftstyle costs in income producing assets (MF in this case). I think this shows an excellent situation to be in :D

http://www.somersoft.com/forums/attachment.php?attachmentid=1213&d=1143626760

I think Keithj's post is excellent, I disagree with point 2 (this is not strictly LOE since it relies on income) because I believe that you can use this income to supplement your rental income and it's really just an adaptation of LOE similar to the other points so.

Myself and my partner need about 50K per year to LOE, my partner has decided that she still wants to work as she enjoys her work, she will be 27 and 1 day when we start our LOE adventure.

We plan to have at least 5 years of equity under our belts (available in LOC’s) when we embark on our adventure. This may not seem a lot to everyone but with the money that we need we feel comfortable with 5 as a minimum. However we have considered drawing down the equity of each property we own up to 80% and having ++10years of equity available to live on, this is obviously higher risk but I suspect in ++10years our LVR will be significantly lower than 80% so borrowing again will not be an issue.

Borrowing seems to be becoming less and less of an issue with low doc and no-doc loans and the rates are becoming very competitive. I'd suggest people register for an ABN as this can make lending easier. Also remember by the time you get to this stage banks will consider you to be a professional investor which again seems to help with borrowing.

I also require a minimum of $1M un-drawn equity at all times before I satisfy my SANF.
 
Great start to a thread and good summary of LOE KeithJ!

I'm wondering if anyone that is using any of the LOE methods (or planning to) can explain how taxation would work?

When I'm explaining this to people it always comes back to the fact that using your equity for lifestyle expenses is not tax deductible so you essentially need to earn two dollars to cover every one dollar spent of your equity (and this would increase geometrically).

The way I see it is that to cover these non-dedunctible expenses your just using your equity more which is tax-free - therefore the difference between deductible and non-deductible debt is irrelevant. Am I on the right track here? :confused:

JS
 
The way I see it is that to cover these non-dedunctible expenses your just using your equity more which is tax-free - therefore the difference between deductible and non-deductible debt is irrelevant.

Correct.

And to combat your growing debt you have your growing portfolio and complementary/supplementary investments to your Standard LOE strategy to create an Advanced LOE strategy which significantly reduces the risks associated with Standard LOE.
 
howdy
what are the tax implications of LOE? Are you subjected to capital gains tax per drawdown? Im assuming we are in a trust structure and using all available benifits of that environment

dags
 
Great post Keithj
Clear explanation.
I still wonder a little about deversifying though.
Over the past 18 months I have kept buying property instead of diversifying to other asset classes. I have increased my assett base by around 24% in the last 12 months by leveraging further into the sydney and Canberra property market. I had the opportunity to put that money into MF's but chose to stick with what I new. I reckon the MF's would have maybe performed better this year but I'm in it for the long term.
Time will tell if I made the best choice. I agree it is all down to SANF.
Thanks for a great post:)
Simon
 
Are you subjected to capital gains tax per drawdown?

No, drawdowns are tax free.

Im assuming we are in a trust structure and using all available benifits of that environment

The system would be optimized with everything in a trust structure but it isn't a requirement for the system to work. I will have some assets in a trust structure and some not, however all my income producing assets (MF's) are in a trust structure which helps me distribute the income tax effectively.

Whats the worst case scenario here... you'd have to sell assets to repay debt???

I think with good planning you should never get to this stage. Now ok "good planning" is easy to say but harder to do. My plan is to release a number of year’s equity therefore allowing for a significant time frame to pass before I require further equity. I also suggest that you regularly monitor your portfolio "growth" either with regular RE valuation or by just monitoring sales, therefore as you start to get close to needing to withdraw more equity (within 2 years) you have time to tweak your strategy to account for the market.

What I also plan on doing is not stretching our LOE capacity to the limit for the first few years. The money we will have to live on will be about the same as we earn working. We are not planning on be extravagant for the first few years until we have settled into our LOE life.

The other point people forget is that when you are LOE you will more than likely be earning money doing something, what else are you going to do all day, all your friends are at work and there is only so much coffee you can drink! Now I know people will say LOE is about not having to work but I suggest it is about being able to do what you want and not what you have to do.
 
jscott said:
I'm wondering if anyone that is using any of the LOE methods (or planning to) can explain how taxation would work?
Hi jscott, Good questions....

Depends on your structure. If you have income you pay tax. If your structure repays you money that you've previously lent it, or you borrow money to live on you don't pay income tax. However, check with your accountant.

jscott said:
When I'm explaining this to people it always comes back to the fact that using your equity for lifestyle expenses is not tax deductible so you essentially need to earn two dollars to cover every one dollar spent of your equity (and this would increase geometrically).

The way I see it is that to cover these non-dedunctible expenses your just using your equity more which is tax-free - therefore the difference between deductible and non-deductible debt is irrelevant. Am I on the right track here? :confused:
Consider borrowing all deductible expenses (rates, insurance, land tax etc). This will increase the deductible borrowings.

Pure LOE
Imagine you've paid off your PPOR, drawn down the equity (eg $500K) & lent it to a trust. The trust borrows more & buys growth $2.5M IP that grows at $200Kpa. For the first 5 years the trust would repay you at (say) $100K pa, it would have to borrow this from the bank to repay the original loan to you. The $500K would be deductible. After 5yrs you'd hope it would have grown by about $1M.

Also, the IPs will become more c/f +ve (or less c/f -ve:rolleyes:) over the 5 yrs.

Note that these figures are just an example - $2.5M isn't enough for LOE IMHO. And Pure LOE is v. risky.

Using LOE as a backup
If you reduce the risk by some of the means suggested above, then you'll need to draw down a lot less from LOE, so it'll last significantly longer - maybe 10 yrs.

I'd suggest in 10 years time you'll won't be worrying too much about deductibility of debt. You may even have sufficient +ve c/f by then to not worry obout LOE at all!

KJ
 
Over the past 18 months I have kept buying property instead of diversifying to other asset classes. I have increased my assett base by around 24% in the last 12 months by leveraging further into the sydney and Canberra property market. I had the opportunity to put that money into MF's but chose to stick with what I new. I reckon the MF's would have maybe performed better this year but I'm in it for the long term.

We really struggled with the concept of instead of buying property we would buy into MF's for the cashflow. We started slow, for every property we purchased we would invest a small % in to MF and it has just grown from there.

I believe it's just a different mind set and different approach, not better, not worse, just different.
 
jscott said:
Whats the worst case scenario here... you'd have to sell assets to repay debt???
Using Pure LOE, the risks are significant.
eg
Japan - 50% fall is RE values over 25 yrs up until last year
Bris - 0% growth for 10 yrs a decade or so ago

If you mitigate the risk using some of the above suggestions, your worst case would be a limited to the same as not using LOE.

Selling assets would be a problem if there'd been no growth (or big falls) over an extended period - you'd probably have -ve equity.
 
simonjulie said:
I still wonder a little about deversifying though.
Over the past 18 months I have kept buying property instead of diversifying to other asset classes. I have increased my assett base by around 24% in the last 12 months by leveraging further into the sydney and Canberra property market. I had the opportunity to put that money into MF's but chose to stick with what I new. I reckon the MF's would have maybe performed better this year but I'm in it for the long term.
Time will tell if I made the best choice. I agree it is all down to SANF.
Hi Simon,

The big problem with LOE is the volatility of growth. By diversifying, the volatility is reduced, since Shares & IP & LPTs are all counter-cyclical. My shares have gone up 50+% over the last 3 yrs, but IP has achieved 0%, the previous 3 years was the opposite. So recently I've drawn down against shares, previously I was drawing down against IP.

You've chosen to mitigate risk by having a large (10+ yrs?) buffer & also reno to create equity. If the current flat period continues for another 22 yrs (like Japan after it's bubble), then some LOEers will be needing to look at other ways of mitigating risk.

Regarding the 'best choice', I think you've made the best choice (for you), & I've made the best choice (for me). I think in the past LOE has always been associated with a single methodology, but as we've demonstrated there are a multitude of ways to implement it.

Cheers

Keith
 
keithj said:
Hi Simon,


You've chosen to mitigate risk by having a large (10+ yrs?) buffer & also reno to create equity. If the current flat period continues for another 22 yrs (like Japan after it's bubble), then some LOEers will be needing to look at other ways of mitigating risk.


Cheers

Keith
You are right. That would require a new strategy implemented long before the money runs out.:) But thats what is fun about investing. The rules of the game are always changing, even just within the property asset class. We have to learn to be flexible and have plans and strategies in place to fall back on if things go in an unexpected direction.
Simon
Simon
 
jscott said:
When I'm explaining this to people it always comes back to the fact that using your equity for lifestyle expenses is not tax deductible so you essentially need to earn two dollars to cover every one dollar spent of your equity (and this would increase geometrically).

I'm not sure if I read this right, but basically if you're not paying tax (draw down) then there's not much use for deductions. If the draw down was for IP expenses, then you could deduct the interest expense from your investment income, but if it isn't, you're only losing that interest deduction. So if you are living purely off equity and not other income, then it's negligible. Does this sound right? It does to me. :)
 
simonjulie said:
I reckon the MF's would have maybe performed better this year but I'm in it for the long term.

Although not strictly MFs, shares have outperformed property in the long term. The usual argument is that while expenses are also less, you cannot gear as much and shares carry a bit more risk (mainly volatility I guess). But I empathise with you being wary; it just doesn't feel as safe dropping $1M on an MF compared to a well-located property. That's going to have to change, for me at least.
 
Keithj = A very good summary of the whole LOE proposition.

I couldn't find living of rents as a option. But basically its that plus #2 and will be starting #3 with my sons, to build up the # of IP's. Overall its really anything where I can use my funds( equity and/or cash) to generate further income.

Just doing some reading re these LPT's you keep mentioning.:)

-T- said:
But I empathise with you being wary; it just doesn't feel as safe dropping $1M on an MF compared to a well-located property. That's going to have to change, for me at least.

Can't agree more '-T-', it has taken me over 2 years to build up to the position I now hold although I could have done it immediately. Its the conservative in me coming to the surface:rolleyes:.

Cheers
 
Hi all,

Excellent thread and discussion Keith!
Just apoint from ealier on....
The $500K would be deductible.

I think you would find that only the interest paid on the $500K would be deductable.

-T-
shares have outperformed property in the long term

Why do people think this?? Is it because the ASX200 or Allords or whatever index has shown great rises over the last 100 years?? It is a common trueism that may not be true.

In a similar vein, median property rises are not necessarily a true indication of how property has performed over the longer term.

bye
 
Top