Example 1 – Investing in a common negatively geared investment property

Property details:

Let us consider a new Queensland property (three bedroom brick residence on large block) that is for sale for $870,000 and is to be rented for $870 per week. Apart from standard rental management and letting fees, rental expenses will include rates ($2250), insurance ($1150), maintenance ($1200), pest control ($250) and other costs totalling $250. The original building construction cost was $430,000 and the purchase price includes $46,000 worth of fixtures and fittings. The purchase costs include normal State Government stamp duty and transfer fees and $1850 solicitor’s fees to cover the conveyancing.

Loan details:

Principal and interest finance can be arranged at 6.4% over 30 years to cover all costs, including purchase and loan costs. The total loan costs ($2,232) include a fixed establishment fee of $500, no mortgagee insurance, and the remainder of the loan costs are as per the program defaults.

Investor details:

The investor’s current annual taxable income is $125,000 per year, his spouse’s is $50,000 and they wish to purchase the property in joint names. They currently own their own home and have estimated annual living expenses to be $45,000 per year.

What if:

If they use their own home as collateral and borrow the entire amount for the investment property, what sort of a return (IRR) can they expect over a ten-year period if the annual growth rate is 5% and the annual inflation rate is 2%.

• What sort of return on investment can they expect?
• How much will they need to find (after tax) to service the debt?
• Can they afford it?
• How many such properties can they afford?
• How much tax would they save?

What are the steps?

1. Choose the investment analysis spreadsheet (Menu: View/Investment Analysis).
2. Property price: Use the left mouse button to click on the property value field in the input column and overwrite the current value with 870k. Hit the Enter key and the value will change to $870,000 and the entire spreadsheet will be updated. Click on the “Property value” row title with the left mouse button and the Property Value dialog will appear. Note that the property price is showing as $870,000. If you wish, you can specify the property address and description for later reference (these items would then appear on any reports that you generate from the spreadsheet). If there were to be any initial renovations or if the property is to be rented fully furnished, the cost of the renovations and the furniture package could also be specified within this dialog. Click on OK (or Cancel) to return to the main spreadsheet with (or without) any changes you may have made in the dialog.

3. Rent: Click the rent field in the input column and overwrite the current value with 870. When you hit the Enter key, the entire spreadsheet will once again be updated. Click on the “Gross rent /wk /yr” row title and the Rent dialog will appear. Note that the rent is showing $870 per week and that a vacancy rate of 2% (1 week vacant per year) is assumed. The item chosen in the rent preferences section should be “per week”. The “per year” option (used mainly for commercial property) would have the effect of showing the initial potential annual rent (i.e. with no vacancies) in the main spreadsheet input column rather than weekly rent. The “Holiday Letting” option obviously pertains to situations where the property is available for holiday letting and the vacancy rate (or alternatively, the occupancy rate) varies seasonally. If the latter preference is chosen, the seasonal rents, periods and occupancy rates can be specified and the item in the main spreadsheet input column would reflect the potential annual rent. Click on cancel to return to the spreadsheet without any changes.

4. Purchase costs: Click on the “Purchase costs” row title and the Purchase Costs dialog will appear. Change the conveyancing costs to $1850 and ensure that the spreadsheet is using the current Queensland scales to calculate stamp duty (click on the Reset Scales button to change them) and transfer of title fees. Click OK to return to the spreadsheet. Ensure that the Tax Deductibility is specified as “In the year of sale (CGT)” as these are considered capital costs and are generally only taken in account for tax purposes if the property is sold. An exception to this is in the A.C.T. where they are considered a tax deduction in the first year of the investment (probably because land there is leasehold).

5. Investments: Change the current amount in the Investments input column to zero to indicate that all costs are to be borrowed (i.e. the investor is using equity in another property as supplementary collateral for the loan and does not have to put any initial cash deposit into the investment).
6. Loan: Click on the “Loan amount” row title to bring up the Loan amount dialog. Note that there are no cash outlays and that the total loan reflects the total of all costs associated with acquiring the property. Click on the Loan Costs button to bring up the Loan Costs dialog. Change the current establishment fees to $500, the mortgage insurance to zero, remove the registration fees for a 2nd mortgage and hit the Enter key. Note that this item will now show as a flat fee rather than a fixed percentage of the loan amount. Note also that items such as search fees and registration of the title are included here in loan costs because they were a condition of gaining the loan. Click on the OK button to return to the Loan dialog with the updated loan costs and note the change to the loan amount. While still in the Loan dialog, click on the Loan Type button to bring up the Loan Interest & Type dialog. Choose Principal & Interest loan type and change the term from 25 years to 30 years and the interest rate to 6.4%. Click OK to return to the Loan dialog and click OK again to return to the main spreadsheet. Note that the “Interest” row title will now have the suffix “(P&I)” to indicate the principal and interest loan type. Note also that the “Investments” row title will have changed to “Investments/principal” and the following columns will show the annual amounts paid off the loan principal.

7. Expenses: Click on the “Rental expenses” row title to bring up the Rental Expenses dialog. Change the costs of rates ($2,250), insurance ($1,150), maintenance ($1,200) , pest control ($250) and other costs ($250)..

8. Building depreciation: Click on the “Deprec. of building” row title to bring up the dialog. Change the building costs to 430k and hit the Enter key. Note that, by default, any building depreciation claimed as a tax deduction will be taken into account in calculating any capital gains tax liability if the property were to be sold. Click OK to return to the main spreadsheet.

9. Fixtures and fittings: Click on the “Deprec. of fittings” row title to bring up the dialog. Change the value of General fittings to 23k and the value in the Low-value pool to 23k and hit enter. (Note: From 1 July 2017, if the property was already established and the fittings are those of the previous owner, they are assumed by the ATO as already being written off and no claims can be made.) In this example, the depreciation claims will be automatically calculated according to the specified effective life and using the diminishing value method. If the value of individual categories (carpets, curtains, etc) is know, it is possible to specify the individual values and rates for each category. It is also possible to specify the prime cost method for depreciation or even to simply specify the annual amounts claimed if that is all that is known. Click OK to return to the main spreadsheet.

10. Tax credits: Click on the “Tax credits” row title to bring up the dialog and change the investor’s taxable income to 125k and the partner’s taxable income to $50k. Note that the method for tax credit calculation will be using taxable income rather than simply assuming that all tax credits accrue at the specified marginal rate. Choose “property in joint names” and click OK to return to the main spreadsheet. Note that the row title will have changed to “Tax credit (joint)” and the input column will show $175,000 (i.e. 125,000 + 50,000) rather than the program default.

11. Capital growth and inflation rates: Click on the capital growth field in the input column and if necessary, change the value to 5%. Likewise, choose the inflation rate field and change the value to 3%. Hit the Enter key and the entire spreadsheet will be recalculated.

What’s the bottom line?

The estimated after-tax internal rate of return should show 22.48% (This assumes that they are calculated using the 2024/25 Australian tax scales).  Their contribution in the first year is $21,473 (after-tax cash flow) or a cost of about $413 per week. The equity built up in the property after ten years is estimated to be $648,048.

Can they afford it?

Click on the Investment Capacity item in the Investor Menu and set Home loan payments to zero (in this case they are assumed to own their own home) and set their total living expenses to $45,000. Note that they can easily afford the investment. Their combined total net income (including the rent from the investment property) is $219,335 compared to total expenses of $148,134, leaving them with net surplus of $71,201.

How many can they afford?

Change the number of additional properties from one to two and note that total income and expenditure is updated automatically (net savings drops to $45,706). Continue to increase the number of properties until the net savings drops below zero (4 properties). Decrease the number of properties by one and note that, in theory, the couple can actually afford to purchase three such properties and still have net savings of $19,035 (see below). Change the number of properties back to one and click OK.

How much tax would they save?

Click on the Tax benefits item in the Investor menu. Make sure that the number of properties is set to one and that Property Ownership is set to Joint names. The screen should show with the additional income in the form of rent ($44,335), the couples’ new total income is $219,335. However, with the addition rental tax deductions ($86,877) from the interest, rental expenses, depreciation and loan costs, their new taxable income is just $132,458. The new tax liability is just $25,239 compared to their present liability of $37,326, a tax saving of $12,087.

Note that if you switch the property ownership to a single name in this example, the total tax saving jumps to $13,613. This is because the highest income earner pays the most tax and conversely, in a negatively geared situation like this, stands to save the most tax.