Investing In Real Estate

Introduction

Residential real estate has always been a popular form of investment. An investment property can be an initial step for first home-buyers who need to build equity in order to secure a family home in the future, or it may provide security for a couple in retirement.

Whatever the reason for purchasing an investment property, the same considerations apply. The following is an overview of the matters an investor should consider when developing an investment strategy.

• Choosing a purchase structure
• Choosing a property
• Investment finance
• Negative gearing
• Capital gains tax

Choosing a purchase structure

Who should own an investment property? Should investors purchase real estate in their own names? Or jountly with their partner? Perhaps a company should own the property. Some investors use trusts, so that income generated by their property can be distributed to a number of beneficiaries.

Some of the structures used to purchase real estate are listed below. It is most important that you have chosen the right structure before any purchase contracts are signed.
Individual Ownership This is the most simple form of ownership, but it is also the most inflexible with regard to tax. There is little opportunity for an individual owner to put the property beyond the reach of creditors, and any action against the owner may well impact upon it. Individual ownership should, in most cases, be limited to the family home.
Partnership Some investors purchase real estate in partnership with friends or associates, and the parnership structure is often used by spouses. However the limitations applicable to individual ownership largely applies to partnerships as well.
The Company Because the benefits of indexation are lost when capital is returned to shareholders, companies are not very useful in the purchase of an appreciating asset. Little asset protection is offered by the company structure, as the company is a “person” as far as the law is concerned, and action can be taken against both the company itself and the shareholders.
The Discretionary Trust A discretionary trust is a structure whereby the trustee hold legal ownership of the property, but holds in on behalf of the trust beneficiaries.

It is the most flexible structure for property ownership, as both income and capital gains can be distributed to beneficiaries of the trust at the discretion of the trustee. Because the beneficiaries of the trust do not have ownership of the property, action against the beneficiaries will not impact on the property.
Other structures There are other structures for the investor to consider, including variations on the trust concept, superannuation funds, combinations of the above structures. Your accountant can advise on these.

Choosing a property

Your choice of property should take into account both long-term and short-term plans. First home-buyers may decide to purchase a home unit as part of an investment strategy, living in it for a few years, and then using as a rentual property.

Similarly, a home may be purchased in a country or coastal area as a rental property, with a view to converting it to a retirement residence later.

After you have determined the purpose of your investment, you are ready to make decisions as to the location, stype and size of the property.
Property location

We’ve all heard the saying, “Location, location, location”. The location of a property will affect a number of factors, including:

• The purchase price of the property.
• The amount tenants will pay to occupy it.
• Long-term capital gain.

But, location isn’t everything. For example, a property in the best location, encumbered by a long-term low-rent lease may be a poor investment. However, a low rental return with tax benefits, on a property located in an area with high capital growth, may be an excellent investment.
Which type of property?

Of course, there are many different types of property that an investor in residential real estate may consider, including units, high-rise apartments, suburban homes etc. But care should be exercised when determining the best type of investment for your purpose.

By way of example, off-the-plan purchases of high-rise apartments have been quite popular in recent times because of savings in stamp-duty, and capital growth between the day of sale and settlement. However, many “mum and dad” investors have been taken down by unscrupulous marketeers who have promoted such purchases as “wealth-creation” opportunities

The crucial consideration when making a decision on an investment property is the property’s “scarcity value”. Anything that is scarce will be sought-after, and therefore more valuable than the comparatively mundane.

Investment finance

Investment loans are usually more expensive that home loans, and you may be required to use some of the equity in your home as security for your investment loan.

Some of the investment finance options are as follows:

Interest only loan

The interst only loan allows the investor to pay only the interest due on the loan, without having to worry about paying any of the principal. The expectation is that the capital value of the property will rise over time, so that on sale the value of the property will be sufficient to pay out the loan in full, with the balance being profit.

Interest only loans are usually for short periods – about 5 years in most cases. When the loan term expires the property can be sold, or the loan can be renegotiated.
P & I loans

This is the most common form of home loan, where both the principal and the interest are repaid during the term of the loan. (Compare with "interest only" loan above.)

Fixed or variable rate loans

Fixed is where the interest rate on a loan is fixed for an agreed period of time, and variable is where the interest rate varies in accordance with the rates in the marketplace.

Negative gearing

The attraction of negative gearing is that it can be used as a tax-saving device. The investment is “negatively geared” if the expenditure exceeds the investment income, resulting in a loss (which is then tax-deductable).

It should always be borne in mind, however, that striving to save tax can be counter-productive if the investor loses sight of the greater goal. It doesn’t make sense to deliberately lose money in order to reduce tax.

Of course, any investment strategy that involves negative gearing should be discussed with an accountant before any firm decisions or commitments are made.

Capital gains tax

Capital gains tax (CGT) is the term used to describe the liability to pay tax on the profit made through the sale of an income-producing asset that was acquired before 20 September, 1985. A person’s principal place or residence (i.e. the family home) is exempt from CGT when sold. However, where an investment property sells for more than its purchase price, it is likely that CGT will be payable. When an investment property is sold, the profit is added to the investor’s taxable income in the year of sale. For more information, see our page on “Capital Gains Tax”.

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