LOE or Living off Rent?

[Bazza]

Hi Guys,

I really like Rixters strategy of "Capital Growth Averaging and Living off Equity" and I have been changing my thinking and have now incorporate this concept into my investment strategy.

But, the Reno Kings had an interesting tip in this months API mag: "The disadvantages of living off equity is that the interest on that part of the loan used for lifestyle in not tax deductible, which creates bad debt. Much better to live of the rent and use your equity to pay for investment property outgoings, such as rates and insurance."

I guess the down side to this is that you pay tax on the rental income whereas if you borrow to fund your lifestyle you only pay interest of say 9% on what you spend. But, then the interest (bad debt) is compounding.

Which is best?

Cheers,

Bazza

 

[Belu]

but you don't pay tax on the rental income because you still have expenses.

Say you have $100k inflow and $100k outflow, net you are even, but if you use a LOC to service the outflow the interest on that is tax deductable, you get your $100k in rent and it is tax free because from a tax point of view you have not made any gain.

 

[Bazza]

but you don't pay tax on the rental income because you still have expenses.

Say you have $100k inflow and $100k outflow, net you are even, but if you use a LOC to service the outflow the interest on that is tax deductable, you get your $100k in rent and it is tax free because from a tax point of view you have not made any gain.

Thanks Belu. I guess if you don't have enough expenses you could go buy another property?

Cheers,

Bazza

 

[Belu]

well then you would have positive cash flow anyway so you can draw less of a LOC?

 

[s_t]

But, the Reno Kings had an interesting tip in this months API mag: "The disadvantages of living off equity is that the interest on that part of the loan used for lifestyle in not tax deductible, which creates bad debt. Much better to live of the rent and use your equity to pay for investment property outgoings, such as rates and insurance."

Add interest to the outgoings in last sentance and you are LOE. They sound a bit confused

 

[Bazza]

Add interest to the outgoings in last sentance and you are LOE. They sound a bit confused

I think what they are saying is to not use your LOC but rather use your income to fund your lifestlye.

Cheers,

Bazza

 

[Rob Williams]

I don't really understand the "the interest isn't tax deductable" argument against LOE.
Surely if you're not paying income tax on the funds you draw down to fund your lifestyle, then it shouldn't matter if the interest cost is tax deductable or not.
Am I missing something here?

 

[Bazza]

I don't really understand the "the interest isn't tax deductable" argument against LOE.
Surely if you're not paying income tax on the funds you draw down to fund your lifestyle, then it shouldn't matter if the interest cost is tax deductable or not.
Am I missing something here?

Agreed. You pay 9% interest instead of tax. But, then that interest has to be separated from your tax deductible interest and compounds over the years.

Cheers,

Bazza

 

[Witzl]

I don't really understand the "the interest isn't tax deductable" argument against LOE.
Surely if you're not paying income tax on the funds you draw down to fund your lifestyle, then it shouldn't matter if the interest cost is tax deductable or not.
Am I missing something here?

Nah i think you got it right.
From my understanding... converting *some* of your debt into bad debt doesnt overly matter, because your income (rent), minus deductable expenses (good debt interest payment), will net you a ZERO or negative taxable income.... therefore no tax.

For my own understand of LOE, i'd like to go over some vaigue numbers...

For example, you have a $5million portfolio, with $3million in loans
Rent is 4%
Interest rate is 9%
You (and your partner) want to live of $100,000pa in hand.

So, you refinance to get $100,000 out, giving you total borrowings of $3.1million.... but only $3million is deductable.
So, $3mil*9% = $270,000 (interest repayments that are deducatble)
Your income is $250,000 (from rent, 4% of $5mil)


... therefore your taxable income is -$20,000 (you made a loss)

... the next year, you refinance up to get another $100,000 out. HOWEVER, you havent paid down the mortgages, so you still have $3million in deductable loans.
OK, so lets say rent goes up 10% this year (like it has for us all this last year)
... so now your interest repayments are still $270,000
... rent income is now $275,000

----> OH NOES!!! We have to pay tax on $5000!!! (heehee)
..........You could avoid this by purchasing another property!



I know i havent put into my figures the fact that you actually have higher repayments because you have generating more debt for your personal income, and how that erodes your equity. Im just looking at the tax side of thing here!
It seems that so long as you have debt on your portfolio with interest repayments that exceed your rental income - you will be OK

To cover the problem of the bad debt compounding, you have CG working in your favour compounding faster than your bad debt, and your can always purchase another property with a higher LVR to increase tax deductions.

Please correct me if im wrong, this is just how I have worked out the LOE strategy for myself.

 

[ianvestor]

I agree you can pretty much remove 'tax deductible' from your vocabulary, once you're LOE.

If your portfolio happens to become positively geared, borrow more and buy more properties and BAM! The portfolio is negative again.

 

[Dazz]

For my own understand of LOE, i'd like to go over some vaigue numbers...

Your income is $250,000 (from rent, 4% of $5mil)


... therefore your taxable income is -$70,000 (you made a loss)


Please correct me if im wrong, this is just how I have worked out the LOE strategy for myself.

Witzl....4% of 5M is 200K, not 250K. You've got a 50K hole in your plan.

 

[VYBerlinaV8]

Alternatively, why not draw down IP equity into another asset class that pays yield? That way you have an number of benefits:
1) You still retain the IP assets, and the associated tax advantages;
2) You don't generate any non-deductible debt;
3) When rents rise, you pay tax only on $$ actually coming in (nett of interest and holding costs)
4) If you choose, you can gradually pay down the IP debts without upsetting the tax applecart (related to point 3 above)
5) the assets you choose (eg shares, managed funds) will still grow in value
6) the yield you live off will grow in value (as rent does)
7) down the track, if you decide you'd like a pay rise you can simply transfer more equity from IP to the other investment (and if you're clever, maybe even tune how much you move based on current rental returns)
8) well chosen shares/funds will include some franking credits to reduce tax liability on dividend income.

I like this approach because it gives a larger 'investment footprint', and means you have three aspects of your investment growing (IP rent and growth and shares/funds growth) that you won't consume until you choose to do so, as opposed to only one (IP growth).

Just my thoughts. Please criticise constructively, so I can tune my strategy!

 

[stumunro]

Alternatively, why not draw down IP equity into another asset class that pays yield? That way you have an number of benefits:
1) You still retain the IP assets, and the associated tax advantages;
2) You don't generate any non-deductible debt;
3) When rents rise, you pay tax only on $$ actually coming in (nett of interest and holding costs)
4) If you choose, you can gradually pay down the IP debts without upsetting the tax applecart (related to point 3 above)
5) the assets you choose (eg shares, managed funds) will still grow in value
6) the yield you live off will grow in value (as rent does)
7) down the track, if you decide you'd like a pay rise you can simply transfer more equity from IP to the other investment (and if you're clever, maybe even tune how much you move based on current rental returns)
8) well chosen shares/funds will include some franking credits to reduce tax liability on dividend income.

I like this approach because it gives a larger 'investment footprint', and means you have three aspects of your investment growing (IP rent and growth and shares/funds growth) that you won't consume until you choose to do so, as opposed to only one (IP growth).

Just my thoughts. Please criticise constructively, so I can tune my strategy!

What shares / managed funds are going to have a positive dividend return over the interest rate of the drawn equity?

I looked into it once, such as the Macquarie Income Fund but alot of the dividend return had a capital gain component which eroded the income to a point where it wasn't worth it. .

 

[Belu]

Is it possible to draw down the equity of say $1mil.

Then give it to a bank and organise it to give you an income (for example) of $220k per year for 5 years.

Would the interest then on the draw down continue to be tax deductable as you used it for investing? and then the money coming from the $220k would have an interest component which would be taxable but the other principle amount which wouldnt?

 

[Belu]

What shares / managed funds are going to have a positive dividend return over the interest rate of the drawn equity?

I looked into it once, such as the Macquarie Income Fund but alot of the dividend return had a capital gain component which eroded the income to a point where it wasn't worth it. .

A lot of banks are paying around 7% franked dividend at the moment. If you can use $500k equity, leverage in at 50% with the interest on the margin loan capitalised, that is a 14% fully franked return on $1mil.

 

[Ausprop]

To cover the problem of the bad debt compounding, you have CG working in your favour compounding faster than your bad debt,
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this is the crux of the problem, no one knows what the CG could be and the best you could hope for now is probably nil, at worst you could be going backwards. mind you it is unlikely the bank would allow you to refi a falling asset with no job anyway

 

[Witzl]

Witzl....4% of 5M is 200K, not 250K. You've got a 50K hole in your plan.

Whoopsie!!!
Anyway, i was just using numbers made up as a basic example to get my head around the idea, to make sure I was thinking about it properly and not getting confused.

this is the crux of the problem, no one knows what the CG could be and the best you could hope for now is probably nil, at worst you could be going backwards. mind you it is unlikely the bank would allow you to refi a falling asset with no job anyway

I do agree with you about not knowing what CG will be, but that is all part of the risk assesment. You would probably want to hedge your bets with a stronger portfolio before LOE if you arent confident with the CG on your portfolio.

As for the banks not refinancing - that's just part of the challenge of investing
As i've heard it put to me before, "The only risk is not being able to get more debt". With the amount of equity you would want to have to LOE, I dont see why the banks wouldnt give you finance with so much security.

 

[sash]

I am going to upset a few people....with what I am about to say....

I do not believe living off an LOE....in theory is works...but on practicalities there are some issues. One of them being the current environment - i.e. credit crunch...the banks may not like this.

In the longer term you are better off with combination of excess cashflow form the properties with a LOE top which is more sustainable in the longer terms as portfolio capital values will fluctuate.

A better scenario would be:

Assume that you have a $5 million portfolio of mostly cashflow positive properties with $1.5 million in loans at 8% per annum interest only. Also assume that rentals per annum at 5% of total portfolio. The portfolio consists of 15 lower end properties (approx 333.33k per property). The cost of maintain each property (strata, insurance, rates, mgmt fees, etc.) is $4000 per property.

This means
Income from rent is $250,000
Interest costs is $120,000
Other expenses is $60,000

If you deduct interest and other costs from the income you are left with $70,000 per annum as income.

If you wanted $100k income you simply need another $30k which you could draw down in goodtimes but perhaps live on the 70k indexed to inflation in bad times. This way you can still pretty much be guaranteed an income as it is coming mostly from rents rather than capital. Capital is more volatile as in times like this the banks will take a more conservative view in terms of valuation and you may risk of not being able to draw down from the LOE if the banks close the credit tap.

This is the strategy I am developing and putting into action. In addition I plan to combine with a Share Option Cover Call strategy to add to additional income.

Any comments would be welcome!

 

[Witzl]

That probably is a more practicable strategy than LOE alone Sash, thanks for sharing
Im a long way off doing either, so im only thinking about things in theory at the moment. When the crunch time comes, i will probably take into consideration several factors to decide how i would like to retire from the dependancy of fulltime work.

 

[sash]

Same dilemna for me....not prepared to give up work till I have mutiple RELIABLE income streams. Being 24 years from retirement (at 65).....the cash could easily run out!

Unfortunately...I am in the rat race for a few more years yet!!!

Having said that the next few years present one of the greatest opportunties...particularly in Sydney!

That probably is a more practicable strategy than LOE alone Sash, thanks for sharing
Im a long way off doing either, so im only thinking about things in theory at the moment. When the crunch time comes, i will probably take into consideration several factors to decide how i would like to retire from the dependancy of fulltime work.