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The Tree Change Dilemma

David Rynne - Tuesday, August 20, 2013

 The Tree Change dilemma: To sell the Sydney property?

Situation: Young couple with 2 children. They have just moved to Albury from Sydney. The husband has a secure job and earns $65,000 per annum. The wife is not currently employed and does not expect to return to work for at least 4 years.

The wife owns a unit in Sydney where they lived which is now rented out. It could be sold for approximately $400,000 and there is a $200,000 mortgage outstanding. Presently the unit is neutrally geared – the rent covers most of the outgoings.

The couple wish buy a family home in Albury. The cost is $300,000 and they will need to borrow $270,000.

The issues

The Sydney rental property provides no tax benefit to the wife. She is not working. The husband does not have an interest in the property and cannot claim any expenses against his taxable income.

The interest on the loan of $270,000 to fund the family home will be non-tax deductible and will need to be paid out of his after-tax salary.

Should they sell the Sydney rental property?

Do they incur capital gains tax on the rental property?

Let’s crunch some numbers

The loan repayments on a 25 year $270,000 loan are currently $1,735 per month. The husbands after tax income per month is $4,276 and the wife receives approximately $800 in family tax benefits. This leaves a family net income of $3,341 per month or $771 per week. For a family of 4, that’s liveable but it does not leave much for comforts.

As noted above, the Sydney rental property covers its expenses. If they sold the Sydney property, they would realise $200,000 which could be put towards the family home. This would leave the couple with a mortgage of $70,000. The loan repayments on this would be $459 per month. In theory this would probably repaid quicker.

So the net cost of holding on to the Sydney property is $1,276 by virtue of higher mortgage repayments on the Albury property.

Can they borrow against the Sydney property, use this to fund the Albury home and claim the interest?

Well they can. But there won’t be a tax deduction. The Tax Office looks at to what purpose the borrowed funds are used for. If the borrowing is funding the family home, there is no deduction.

Capital gains tax on the rental property?

No.  The tax laws provide an exemption for a property which had previously been occupied as a principal residence. This exemption can apply for up to 6 years if no other property had been purchased as a principal residence. Where a new property has already been purchased, the exemption window is 6 months.

Any alternatives?

Say they want to keep the Sydney property as they think it has growth potential. One option is for the wife to sell the property to the husband at arm’s length. He would borrow the entire amount in his own name. The funds released to her could be used to buy the family home.

This alternative may incur NSW stamp duty of approximately $14,000 plus other costs such as mortgage insurance. However, the husband would have a net rental loss of $20,000 per annum which would offset his income. At his marginal tax rate of 32.5%, the after tax cost would be approximately $13,500 per year – or $1,125 per month. The couple would then need to assess whether this cash flow cost is affordable, the risks involved in holding the investment and the growth potential.

From a financial perspective: Does the net present value of the future after-tax capital gain exceed the out of pocket cash flow of holding the property? This is a fundamental question that should be asked when making any property investment decision