Why sea-changing could be a huge tax savings

The massive wave of baby boomers nearing retirement and a sharp fall coastal property values make an often overlooked tax and investment strategy much more appealing. 

This innovative strategy involves typically middle-aged couples buying their next investment property based on two fundamental criteria: its potential returns and its potential as a future retirement home. 

The new property is treated strictly as a negatively geared investment property for up to 20 years or so until the owners are ready to sell their existing family home and move into it. 

Depending upon the circumstances, the breaks from income tax and capital gains tax can be outstanding – and, perhaps, unexpected. 

Tax adviser Gordon Cooper is convinced that investing in the property in your own name is likely to produce far superior after-tax benefits than pursuing an identical strategy through a self-managed super fund. 

Cooper, the principal of Cooper and Co in Sydney, believes the strategy of buying a future retirement home – initially as a geared investment – is extremely timely given the rapid ageing of the population. 

Louis Christopher, managing director of property adviser and forecaster SQM Research, says the fall in the prices of coastal houses – which may be suitable for future retirement homes – could create good buying opportunities. 

Christopher points out, for instance, that Gold Coast prices are down by 15% from a high in 2008 and prices on the NSW Central Coast are down by 12% from a peak in June last year. 

“It is probably time to research these properties,” he says, “but their prices could fall a bit more.” 

These are the four steps involved in this strategy: 

1. Borrow up to entire purchase price

Cooper says borrowers following the strategy would typically take an interest-only loan to finance the property, using their existing family home as loan security. This will help maximise their tax benefits. 

2. Claim negative-gearing tax breaks

The annual deductible shortfall between the rent and the costs of interest on the loan, maintenance, council and water rates, and insurance could eliminate much of the tax on your salary. As Cooper emphasises, salaries are often at their highest in the last decade before retirement, making the negatively gearing tax breaks highly rewarding. 

3. Minimise CGT

When you ultimately make the property your permanent home, it will gain the CGT-exempt status of your main residence. However given the property will not be your home for some years, you are likely to face a CGT bill upon its eventual sale. 

Fortunately, there is a smart way to minimise that CGT liability. 

Say you owned the property for five years before moving in and making it your home for another 15 years. Cooper explains that you would be liable for CGT on a quarter of the assessable capital gain. 

But now Cooper adds a twist that may surprise many property owners. 

“In calculating your CGT liability [upon the property’s eventual sale], you can subtract a proportion of the non-deductible expenses,” he says. 

You would have incurred these non-deductible expenses after the property ceased being used as an investment and had become your home. And such expenses would include council rates and interest on any outstanding mortgage. 

Cooper says that after taking into account these non-deductible expenses, you might actually end up with a capital loss.

4. Consider the SMSF alternative

Some investors arrange for their SMSF to buy their future retirement homes as geared investment properties as an alternative to gearing the property in their own names. 

The apparent attractions of this SMSF strategy are two-fold. First, your super fund is likely to have enough money to pay the deposit or first instalment on the property. Second, you could arrange for your fund to eventually transfer the property into your name as an in-specie (non-cash) pension payment. 

Your SMSF would not be liable for CGT upon the transfer of the property into your name provided: 

• The property was backing the payment of a superannuation pension. (Fund assets supporting a pension are exempt from CGT and income tax.) 

• The transfer of the property into your name as a pension payment did not result in the full pension account balance being paid out. (Strictly speaking, the benefit is treated as a partial commutation to a lump sum.) 

However, Cooper is convinced that high-income earners in particular would gain higher after-tax returns from negatively gearing the property in their own names rather than gearing through a SMSF. This is despite the fact that the property will not be subject to CGT if eventually transferred into your name as a non-cash pension payment. 

“I think it is very hard to see how the maths can work to show it is an advantage to gear through your SMSF rather than in your own name,” Cooper emphasises. 

This article first appeared on Property Observer. For more on self-managed super funds, download the free eBook.