Question Mark

High income earning property investors will be hardest hit by a reduction in the effectiveness of negative gearing, following the broad-based income tax cuts announced last night.

But I’ve got to say upfront, it’s a pretty soft landing.

The reduction in the top marginal tax rate, from 47¢ in the dollar to 45¢, make negative gearing slightly less effective. But the reduction in negative gearing benefits will be more than offset by a significant increase in net weekly income.

For example, someone earning $150,000 a year with a negatively geared investment property worth $350,000, will only lose $200–300 a year in negative gearing benefits. At the same time, their net income will rise by a whopping $6200 a year.

Therefore, I very much doubt that the slight reduction in the viability of negative gearing will translate to a reduction in activity at the top end of the market. If anything, the increase in working income will encourage more activity.

Separately, reductions to superannuation contribution limits will affect current property investors aged 50 and over who are planning to sell their property before retiring and transfer the sale proceeds into superannuation. Many of these investors will need to rethink their strategies.

The budget will have little effect on the remainder of taxpayers, and I believe the residential market will continue to recover as have been forecasting in previous editions of Question Mark.

A key force behind the price moderation in our major capitals over the past few years has been the absence of investors, who left the market when prices moved beyond their tolerance levels.

The Government hasn’t announced any of the mooted changes to capital gains tax, so there’s no further disincentive for investors. At the same time, the widespread income tax cuts won’t do much more than partially soften the effects of petrol price increases and last week’s interest rate rise, so investors won’t face increased competition from first-home buyers.

In this environment, investors will trickle back into the market over the rest of 2006. I expect this will increase during 2007 when the sharemarket begins an inevitable adjustment.

COMMERCIAL PROPERTY

My partner and I are in our early 60s and getting ready to change to a self-managed super fund allocated pension. We have about $500,000. Our financial adviser recommends unlisted and listed property with a major bent to commercial property. From what I’ve read, these asset classes seem a bit risky, and I’m not keen on the idea of being locked in for seven to 10 years. What’s your opinion?

I don’t know all the particulars of your situation, particularly your risk profile, and I’m not licensed to provide advice on indirect property investment through listed or unlisted trusts. Therefore, I’m not in a position to give a second opinion as to whether your adviser’s recommendations are appropriate.

However, I can say in general terms that all investments involve some degree of risk. It’s your adviser’s job to consider risk when recommending an asset allocation.

Within this context, all investment vehicles go through ups and downs. Diversifying your portfolio by spreading your money across a number of property trusts will help reduce volatility and therefore the degree of risk.

Holding your investments for the long-term will also reduce risk, by giving them time to ride the ups and downs of market cycles. Seven to 10 years is a reasonable investment timeframe for commercial property.

Ultimately, it comes down to the “can I sleep at night?” rule. If you lie awake at night worrying about what you’re doing with your money, or if you don’t feel well informed and completely comfortable with what your adviser has recommended, it might be a good idea to seek a second opinion from another financial adviser before you commit to anything.

CITY OFFICE

I'm considering buying a 65 square metre office “off-the-plan” in a strata office development in Perth’s CBD. The cost is about $5400 per square metre, with a guaranteed 6% net rental return in the first year. There’s no parking facility onsite.

What is your opinion regarding the medium-term outlook for this sector? Do you think it is a reasonable investment for its location and price? Is the lack of a car space a big deterrent? Are there any major downside risks? I would appreciate your frank opinion.

It’s important to realise that the chief value of commercial property lies in its ability to attract high rental income. Commercial properties are only as viable as the businesses who lease them.

Within this context, I have three main concerns about your proposed investment.

First, such a small floor space is likely to appeal mainly to small businesses, so you’re limiting the potential pool of tenants from the outset.

Second, the relatively high failure rate of small businesses, particularly in the first 12 months to two years, exposes to you to considerable risk of interruptions to your income stream. If you’re unable to find a tenant after the rental guarantee expires, or you find a tenant who turns out to have cash flow problems and can’t make the rent your investment will become more of a burden than a bonus.

Third, car parking is very expensive in most major cities, so potential tenants will see considerably less value in an office that doesn’t have onsite parking for the use of employees and guests. This will also be a thorn in your side if and when you eventually sell the property.

CAPITAL GAINS TAX

In the April 12 edition of Question Mark you said that “when you buy a home in your name and live in it for longer than 12 months, you do not have to pay any capital gains tax on the sale price. This is known as the “primary residence” exemption.”

What if I lived in a property for more than 12 months, rented it out for a period (say two years) then sold it? Will I have to pay any capital gains tax on the sale price? If I buy a second property afterwards to live in, can I claim a primary residence exemption for that as well?

If you own a home and live in it for more than 12 months and then rent it out, you are entitled to claim the main residence exemption for up to six years, while at the same time claiming ongoing tax benefits such as negative gearing.

Only one property is entitled to a main or primary residence tax exemption at any one time. Once you buy your new home, you have a six-month window of opportunity to sell the existing house and still claim the exemption.

In determining your eligibility for the main residence exemption, the tax office will look at the reasons you moved out of the house. Some reasons, such as being transferred interstate for your job or the house no longer suiting your lifestyle requirements, may be considered legitimate.

However, if the tax office believes you moved out of the property and rented it out primarily to minimise your tax liability, it may consider this to be tax evasion and you could have a real problem on your hands.

LINE OF CREDIT

I set up a line of credit with a limit of $250,000 to purchase an investment property. Each month my salary and rent go into the line of credit. I use my credit cards to pay bills and purchases, then transfer the required amount from the line of credit to my credit cards before the due date and pay them off in full.

I thought this was a great way to save money. However, a friend says that each time I draw money out of my line of credit to pay my credit cards and other expenses, this portion of the loan will no longer be deductible so I am reducing the overall tax-effectiveness of my loan. Is this right and if so, what should I do about it?

Your friend is right. The fact that a line of credit or loan is initially set up for investment purposes doesn’t mean that every redraw from the account is tax deductible. The purpose for which the funds are used is what determines tax deductibility. For example, if you redraw funds to pay for essential repairs to your property, or to pay a rates notice for the property, the tax office would in all likelihood consider these expenses tax-deductible. If you use the funds to purchase goods or services for personal use, the tax office is unlikely to be so generous.

In short, you should never draw from an investment loan unless you are going to use those for funds for demonstrably investment-related purposes.

A better alternative may be to set up an offset account to the investment line of credit. This will give you the convenience of having your salary and rental income paid into an everyday transaction account, but you’ll be paying your credit card.

Mark Armstrong is Director of Property Planning Australia www.propertyplanning.com.au, an integrated property advisory and mortgage sourcing service. He also writes for Australian Property Investor magazine www.apimagazine.com.au.

You can email any questions regarding property to Mark Armstrong right here, by clicking questionmark@eurekareport.com.au