Reply: 1.1.1.2.1.2.2.1.1.1.1
From: Michael G
Hi all,
This is my effort to help with Mike's questions.
If we look at Steve McKnight's and Rick Otton's style of wrapping, there is two distinct tactics.
Steve promotes the idea of long term positive cashflow. The goal being to have the property wrapped to the wrappee for the full term and enjoying the benefits of that cashflow.
If we use Dale's example of a property purchased for $100k @ 7.5% and wrapped for $120k @9.5% we see the wrapper enjoying a cashflow of $325/mo for the term of the installment contract.
$325 represents the difference between installment payments on a $120k loan and a $100k loan. There is no distinction made between "capital gain" on the principal payments or "income gain" on the interest payments. It is all now treated as "taxable income"
Now Rick promotes refinancing, the idea being to "turn-over" your capital as quickly as possible. The objective of this strategy is getting the capital gain back as quickly as possible so that can be utilised over and over again.
In Dale's example, this is the difference between the $100k purchase price and $120k sale price.
So in scenario 3, the $120k sale price was reduced initially by a $10k deposit by the wrappee. So in year 1 the wrapper now has $10k to declare as income. Now remember the property was marked up by $20k ($120k sale price). So this $10k represents 50% of the marked-up price.
So what remains is a outstanding balance of $110k still @ 9.5%. The repayments of which are $961/mo.
Remembering that our 1st mortgage repayments are $723 ($100k @ 7.25%), this means the wrapper is still collecting $238/mo
So as Dale points out in year 1 the wrapper has to declare a $10k lump sump profit + 12 x $238 payments (total $12,856).
Throughout the next year the wrappee continues to make regular repayments of $238/mo, but at the end of the 2nd year decides to refinance. This could be due to the value of the property going up.
Now the nature of mortgages is that for the 1st couple of years, the borrower is mostly paying interest, and very little principal. To keep things simple, Dale's example has rounded of the very small principal paid down to zero.
So in scenario 3, at the end of year 2, the wrapper's original loan of $100k (remember property was 100% financed), and the wrappee's $110k installment contract price (remember they bought it for $120k less $10k deposit), hasn't changed at all in two years.
So, when the wrappee decides to "cash-out" the wrapper, they go get a loan for $110k and pay this to the wrapper (thus paying the full balance owning on their contract).
The wrapper in turn pockets $10k and pays out their own $100k loan they used to initially secure the property.
So at the end of year two the wrapper has to declare 12 x $238 monthly payments (the difference between 1st mortgage and installment payments) PLUS the lump sump difference gained when they were cashed out.
This would be a total of $12856 for year 2.
You see $12865 x 2(years) = $25,712, now remember the markup was only $20k, so the extra $5k was the interest charge on the contract.
I hope that didnt make matters worse.
But now I have a question. In scenario #3, I wonder if the ATO will treat the deposit and payout lump sum payouts as capital gains or as income?
I wonder this because they make the distinction that only capital losses can be offset by capital gains.
So for a wrapper could all their operational expenses like advertising, phone calls, etc be written against these lump sums profits, all will they be restrained to only reducing this liability against a loss like a potential fire sale?
One model I can think of is if they "wraps" were held in trusts and let's say these trust held negatively geared property. Then ideally you would want to be able to offset these "lump sum payments" (possible capital in nature) against the negative cashflow of say an appreciating property.
But it would be no good if one were to get CGT on the lump sums and still have a negative loss on the other property.
I hope that last bit makes sense. You thoughts would be greatly appreciated on this one Dale
Michael G