Renting out your former family home does not always make sense.
Property commentators are partial to a theory or two about what does and does not constitute a good investment.
One of the most common theories is that because residential property can provide solid capital growth over the long term, you should never sell it.
It is true that residential property should be held for as long as possible. At least seven to 10 years, or a full property cycle is enough to maximize compound capital growth and minimize the effect of transaction costs such as stamp duty and agent fees.
However, a property portfolio, whether it is your home, a rental property or both, is only effective if it genuinely serves your lifestyle and financial requirements.
Major life events can alter these requirements, justifying a change in your property portfolio.
This is no more evident than in the common practice of upgrading to a larger and more expensive family home, while holding on to the previous home and renting it out.
At face value, this seems like a valid decision. Renting out your old home is logistically easier than selling, and you can put the rental income towards the loan repayments.
There is probably a bit of sentimentality involved. By holding on to your former home, you are keeping a foothold in a familiar environment. It is not goodbye. It is just a bit of time apart.
Sentimental attachment is fine, but only if the numbers stack up. After all, the property is not your home anymore. It is an investment.
When you borrow money to buy a property, most government taxation offices recognize two kinds of debt. The first kind is debt you take on to purchase a property that produces income in the form of rent. This debt is known as “deductible” because the tax office allows you to claim it as a deduction against your taxable income.
The second kind is debt you take on to purchase a property that does not produce income, i.e. the family home. This debt is known as “non-deductible” because you cannot claim it against your income.
If you have debt on an investment property and debt on a family home, it makes sense to minimize the proportion of debt that lies with your home because it is non-deductible.
Say you want to upgrade from your current family home, which is worth $500,000. You have worked hard to pay off your loan and the property is debt-free. You do not know whether to keep it and rent it out, or sell it and put the proceeds towards your new home.
Option A: rent, then buy. The rental return on a $500,000 property is around 4%, or $20,000 per year. If you upgrade to a family home worth $700,000, you will have to borrow the whole purchase price. At an 8% interest rate, you will pay $56,000 in interest each year - none of it tax deductible. At the 2006-07 top marginal tax rate of 45%, you will also pay $9,000 tax on the rental income.
Option B: sell, then buy. Since you have no debt on your old home, selling it will give you $500,000 cash in hand to put towards your next home. You only need borrow $200,000. At a rate of 8%, you will pay $16,000 per year in non-deductible interest.
If you then borrow $500,000 at 8% to buy an investment property, you will pay $40,000 per year in deductible interest. Take away the $20,000 in rental income and you are effectively paying $20,000 in interest. Because it is deductible, you can claim it against your taxable income. At a marginal tax rate of 45 cents in the dollar, you will pay interest of $11,000.
Option A leaves you $45,000 out of pocket, while Option B sets you back $27,000. In short, keeping your old home will cost you $18,000 per year. The same principle applies if you are on a lower tax rate. It is hard to argue that this makes good investment sense.
With Option B you will pay an additional $35,000 in agent’s fees and stamp duty. But as you are saving $18,000 per year in interest, it will only be two years before you recoup this cost.
The prospect of leaving your old home for good may be hard to face. But if you are having second thoughts, doing the math is the only way to make a decision that is genuinely in your best interests.
