Investment or attachment? Why renting out your former home doesn’t always make sense: Mark Armstrong

Property prices are on the move with RP Data reporting the Melbourne and Sydney house prices moving by around 5% in the September quarter. This movement will bread more activity and many new buyers will begin to enter the market.  

One of the major entrants will be home buyers who are looking to upgrade their family home and they will begin to grapple with a major dilemma, should they keep their old home and rent it out or sell it?  

Many people believe that, because residential property can provide solid capital growth over the long term, you should never sell it under any circumstances.  

It’s true that residential property should be held for as long as possible to maximise compound capital growth and minimise the effect of transaction costs like stamp duty and agents’ fees.  

However, a property portfolio (whether it’s 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, whilst holding onto 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.  

But let’s be honest — there’s probably a bit of sentimentality involved. By holding on to your former home, you’re keeping a foothold in a familiar environment. It’s not goodbye; just au revoir.  

Sentimental attachment is fine, but only if the numbers stack up. After all, the property isn’t your home anymore; it’s an investment.  

When you borrow money to buy a property, the Tax Office recognises 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 doesn’t produce income, i.e. the family home. This debt is known as ‘non-deductible’ because you can’t claim it against your income.  

If you have debt on an investment property and debt on a family home, it makes sense to minimise the proportion of debt that lies with your home, because it’s non-deductible.  

Let’s do a few sums. Say you want to upgrade from your current family home, which is worth $500,000. You’ve worked hard to pay off your loan and the property is debt-free. You don’t 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. This income will be included in your taxable income and at a 40% tax rate you will loose $8,000 in tax. If you upgrade to a family home worth $700,000, you’ll have to borrow the whole purchase price. At a 5% interest rate, you’ll pay $35,000 in interest each year — none of it tax deductible.  

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 to borrow $200,000. At a rate of 5%, you’ll pay $10,000 per year in non-deductible interest.  

If you then borrow $500,000 at 5% to buy an investment property, you’ll pay $25,000 per year in deductible interest. Take away the $20,000 in rental income and you’re effectively paying $5,000 in interest. Because it’s deductible, you can claim it against your taxable income. At a marginal tax rate of 40 cents in the dollar, you’ll pay interest of $3,000.  

Option A leaves you $23,000 out of pocket while Option B sets you back $13,000. In short, holding your old home will cost you $10,000 per year.  

It’s hard to argue that this makes good investment sense and if interest rate move north it will tighten the noose around your neck.  

Yes, with Option B you’ll pay an additional $30,000 in agent’s fees and stamp duty. But as you’re saving $10,000 per year in interest, it will take around three years before you recoup this cost.  

The prospect of leaving your old home for good may be hard to face. But if you’re getting a case of the wobbles, doing the maths is the only way to make a decision that’s genuinely in your best interests.  


Mark Armstrong is a director of iProperty Plan, which provides independent analysis and tailored advice to investors and home buyers.


Mark Armstrong

Mark Armstrong

Mark Armstrong is a director of ratemyagent.com.au, Australia's number one real estate agent rating website.

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