Your ability to expand your property portfolio hinges on how well you structure your loans. We show you how to do it right. Portfolio planning and preparation are crucial to the long-term success of your property investment endeavours, and they do go hand-in-hand with structuring. There are two parts to structuring:
- The loan structure of your investment portfolio
- The structure you choose as an investor from which to own your assets.
Ironically, while trying to save themselves a buck on their next property deal, many investors commonly overlook the importance of how they structure mortgages. They only realise that this is an area that requires at least as much consideration when it’s too late and they’ve lost a pretty penny. As an investor you need to not only consider what is best for you now, but also how your financial decisions will impact on you in the future. Put simply, you need to have a clear and concise plan of attack in all aspects of your property investment endeavours, and how you structure your loans is an important part of that plan. Get it right and it could save you thousands. In this chapter that’s exactly what I intend to help you do.
Why is loan structuring so important?
A loan structure will influence many things including the interest rate and fees you pay, the amount of tax that you pay, the amount of flexibility you have, your access to additional finance (i.e. your ability to invest more) and so on. A sound structure will ensure the following positive outcomes.
1. Debt is tax-effective
A good loan structure will ensure that your debt is tax ¬effective. One of the most common problems that investors face is an inefficient split of tax-deductible and non¬deductible debt. We have already learned that a home loan is a non-deductible debt and an investment loan is a tax-deductible debt. This means simply that the costs associated with setting up and servicing the loan for an investment property can be offset against your assessable income for tax purposes, whereas charges associated with your home loan cannot. It makes sense then to have the larger loans (that cost you more) financing tax-deductible debt. One of the mistakes many investors make is to have their home loan as too large a proportion of their total debt. Of course, we can’t be too tax-focused when it comes to loan structuring as tax is only one of many considerations. However, optimising your tax position will increase your cash flow and cash flow is very important when it comes to building an investment property portfolio.
2. You retain flexibility
Flexibility relates to your ability to make changes to ensure you make the most of opportunities. For example, a flexible structure will allow you to access a sum of money quickly so that you can take advantage of an investment opportunity that has unexpectedly arisen, or refinance one of your loans with a lender that is offering a sensational fixed rate for a limited time. An inflexible debt structure can also prevent you from ensuring you take the most tax- effective approach.
3. Risk is contained
Rarely do investors take a balanced approach to assessing risk. Investors tend to be either overly conservative and spend too much time focusing on why they shouldn’t invest or they are blind to risk and look at everything through rose-coloured glasses. Risk management is often about playing the devil’s advocate and thinking about all the things that could go wrong. What if you lose your job? What if you fall ill and can’t work? What if a tenant gets injured in your property and sues you? How you structure your loans can minimise this risk. For example, if you run into financial difficultly you may decide to sell one of your investment properties so that you can use the cash proceeds to pay for living expenses over the next few years. If you have the correct structure in place, this can be a good strategy. However, if your loans are structured incorrectly then the bank can control all the sale proceeds and force you to repay debt, rather than access the funds to stay afloat.
4. Account-keeping is easier
The more straightforward your account-keeping, the happier your accountant and the tax office will be. The onus is on the taxpayer to prove why they are claiming certain deductions. For example, if you have one big loan that relates to multiple properties and you sell a property but don’t repay any debt (because you believe no debt relates to that property), the onus is on you to demonstrate to the ATO that you are correct. If there’s any ambiguity (due to poor record-keeping), you risk the deduction for interest being denied. A correct loan structure will ensure you have a sound basis for claiming deductions through separating loans by property and purpose. There are principally two ways to structure your loans – some might say, a right way and a wrong way! In my opinion in the majority of cases, the right way to structure your investments is to take out stand-alone loans. The alternative (wrong way) is to cross-securitise.
Setting up stand-alone loans
Stand-alone loans provide investors with the greatest flexibility both now and in the future. The general methodology is to establish a stand-alone loan – secured by one existing property only – to finance a 20% deposit plus costs and arrange a further separate loan (secured by the new property only) for the remaining 80%.
Many people fail to make any contingency plans to allow for unexpected changes in their circumstances. They might set up a loan structure that is totally suitable for their circumstances today, but that may not offer enough flexibility to adapt to the new state of play tomorrow brings. Remember life changes are often unexpected and unpredictable, but they are also inevitable and often unavoidable. How did John Lennon put it? ‘Life is what happens to you while you’re busy making other plans.’