Why hanging onto your apartment after buying a family home doesn't add up

It happens so often there must be a pattern. A young person - mainly a woman in their late 20s or early 30s, either expecting a child or with a young family already - says: "We're thinking about buying a new house."

My response: "That's great news."

"We think we need somewhere bigger for the family to grow up."

"Of course," I say.

"But I wanted to ask you, how can we structure it so we can hang onto our apartment?"

"Why do you want to do that?" is my standard response.

"Well, it's such a good apartment and we would really like to hang onto it as well. We really love it."

And here's where my furrowed brow starts to worry them.

"Why would you want to do that?" for the second time.

Now it's their turn to look a little frustrated with my lack of instant approval.

"Well, we have plenty of equity in the apartment, and we can rent it out so it doesn't really cost us anything ... and we can borrow against the apartment to buy a house."

And this is where the lecture starts.

If the couple try to hang onto the apartment, in most situations (not all, granted) it will create a situation where tax is working against their savings and the double gearing will add risk to their strategy in the event of unemployment or (god forbid) separation.

Let's go back to basics. Interest on a family home is non-tax deductible. So that mortgage repayment has to be found from after-tax wages. No deductions.

Interest on investments (property, shares or business) is tax deductible. So if you earn more than $180,000 a year you get a 47% tax deduction on the interest (and less Medicare levy and budget repair levy). Effectively the 4.5% will cost you 2.3% after tax. If you earn more than $80,000 a year it is 37% tax (plus Medicare levy of 2%), so the loan will cost you 2.75%. Note the after-tax cost is higher for the lower income earner because their tax rate (and tax refund) is lower.

So it is instantly obvious that having a loan that is against an investment is significantly more beneficial than a loan against a family home.

Now go back to the question. If a couple hang onto their current apartment, which they live in, and turn it into an investment then, yes, the interest will become tax deductible and will offset any rental income they receive.

But how do they pay for the new house. The tax office rules are quite specific that once you pay off an investment loan you are not allowed to reborrow and claim a tax deduction. So ripping the equity out of the apartment and replacing it with debt is not on ... not if the tax office cottons on.

With the family home, the offset of the lack of tax deductibility of the interest is its exemption from capital gains tax.

Take the example of a family with an apartment worth $600,000. Say they have been fortunate and they have 40% equity in it - so $240,000.

The interest on the remaining $360,000 debt, at 4.5%, equals $16,200. If they hold onto the property and it delivers a yield of 4%, the income will be $24,000. So they make a profit - give or take - of $7800, which they add to their wages and pay tax at 37% (plus 2% Medicare) ... so they end up with $4760.

Looks good so far. But let's say they want to buy a new house for $800,000.

If a lender is prepared to take on the deal, the interest will be $36,000. But they have the after-tax rent from their existing property, so they pay a net $31,240 interest. For simplicity I haven't included principal repayments here.

Now let's take the alternative option. Sell the apartment, realise the gain and put it towards the new property. Their debt will be just $560,000. The interest payments on that will be $25,200 and the family cash flow will be better off by $6000pa after tax, which they can put towards the mortgage, their lifestyle or investments.

It's safe, I know. An aggressive investor will say that $6000 is just 1% of the apartment's value. If it increases by that amount each year the strategy of holding the two properties pays off.

The bigger problem for most young couples is coming up with the extra $6000 ($115 a week after tax) to keep the strategy afloat and the kids in food and clothes.

As clever investment types told me years ago, one of the tricks of our tax system is to pay down your home mortgage and borrow against your equity in it for investment purposes. This immediately turns a non-tax-deductible debt into a tax-deductible one.

That's the secret but there is one difficulty: finding the cash to pay down the mortgage - even for a day - and having the investments ready to go.

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