Common Restructure to Become More Tax Effective (Personal Home becoming a Rental)

9 January 2018

 

Common Restructure to Become More Tax Effective (Personal Home becoming a Rental)

 

 

 

 

 

Are you trying to get ahead on the property ladder by converting your current personal home into a rental, and then buying a new personal house?

This is an example of poor advice that I have recently seen, followed by a common restructure that makes the overall situation more tax effective.


Poor advice and current situation
 
Jack and Jill own a personal house (House A), worth $500,000 with $50,000 of debt in their personal names. 
 
Jack and Jill have been advised to keep House A in their personal names.
 
They have purchased a new personal house (House B) for $600,000 with a $600,000 mortgage.
 
Outcome – Unfortunately with this structure, none of the interest on the $600,000 loan is deductible.  Only the interest on the $50,000 loan on House A will be deductible.  At say 5% interest, this would be a $2,500 deduction, reducing tax by $825 (if at 33% tax rate).
 


Restructure
 
A common restructure is to sell House A to a Look Through Company (LTC) at fair market value.  The LTC would then borrow 100% (can do with one or two banks!) being $500,000.  The interest on the $500,000 is deductible as it is being used to buy a rental property.  At say 5% interest, this would be a $25,000 deduction, reducing tax by $8,250 (if at 33% tax rate).
 
Jack and Jill would then receive the $500,000, pay off the $50,000 current debt, and use the $450,000 cash towards House B purchase.  This way there would only be $150,000 personal debt left, where the interest is not deductible.
 
This creates a tax advantage of $7,425 per year!
 
For any restructure, it is important to look at the cost versus the benefit.  There can be catches such as depreciation recovery, tainting and the Brightline test to consider.  Also, whether there is a commercial reason for the transaction.  So it is important to get expert advice.  QB 12/11 from the IRD gives some great information on this type of transaction as well, and confirms that this type of restructure is not tax avoidance, but it does depend on the exact circumstances!
 


The information below is from my 14/07/17 blog.  It is important reading if you are thinking of converting your current personal house to a rental:

 Convert Your Current Personal House to a Rental?

When trying to get ahead on the property ladder, a lot of people move to a new personal home and convert their existing house to a rental.  Unfortunately, this is often done for emotional reasons!

If you are thinking about doing this:

1)  Is your existing house a good rental?
Is there high tenant demand in the area?  Look at population figures for the area and talk to a local property manager.
Will you be able to attract a good tenant?
Is the property easy care and low maintenance?
Is there an opportunity to add value in the future?  For example, subdivide or add a minor dwelling.

2)  What is the cash flow?
As a starting point, I would work out the Gross Yield.  This is 50 weeks rent divided by the property value *100.  For example, $400 per week * 50 = $20,000 divided by value of $400,000 would give 5% Gross Yield.

The Gross Yield gives an indication of the cash flow:
5% or under is going to be quite negative cash flow based on 100% mortgage.
7% or better should break even or be positive cash flow.
Between 5% and 7% is still likely to be negative cash flow, but a smaller, more manageable amount.

Review the income less the full expenses.  The example below shows a $8,784 loss expected each year before tax.  After tax refunds, this drops to $4,914 per year or $94.50 per week.


 

   

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3)  What happens if interest rates go up?
At 6.5% interest, the loss after tax refunds increases to $9,950 per year or $191 per week.

4)  Can you afford the cash flow losses?

5)  Do you want to gamble that the property will go up more than the cash loss?

6)  Or do you have a plan to change the cash flow?

  • Minor dwelling to increase rent
  • Subdivide long term and sell section, or build second rental on section
  • Inheritance coming that can reduce the rental debt.  NOTE:  you are likely to pay off any personal debt first.


Often I find that personal homes are not great rentals and that it is better to sell the existing personal house and buy a specific rental, with better cash flow or better long term options.

I hope you have found this topic of interest.


Kind regards
Ross Barnett 

 

 
 
 
 

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