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As Australians, we’re probably among the world’s most voracious buyers of investment real estate. It’s entrenched in the national mindset as a tried-and-true way to build wealth, through the reassuringly tangible method of bricks and mortar.

And why not? Though property markets have ups and downs like any other, the vast majority go up in value over the long term, and a well-located property, properly tenanted, can generate a reliable yield, pay down your debts and in some circumstances slash your tax bill.

The only problem is, so few of us think about the exit. How many of us who have bought investment property have thought clearly about exactly how, why and when we’re going to get out again?

We ought to have that in mind. There are tax issues, for a start, around capital gains, and there are questions about your debt position, and need for cash, as you approach retirement. Ideally we’d think about this at the start, not just near the end.

“Many people don’t think the investment strategy right through to its conclusion,” financial planner Paul Moran says. “Especially with investment property purchases, the end profit can be very large and hence there can be a significant capital gains tax liability.

“In fact, many investors don’t understand that there’s no such thing as [a specific rate of] CGT – rather, the taxable capital gain is simply added to your other income for the year and taxed according to marginal rates.”

To learn more, we asked Kim Wight at Smartline Personal Mortgage Advisers to model a few of the scenarios that commonly arise around investment property and the exit strategies that would work within them.

“It’s an afterthought for many people,” she says. “When people come to see me wanting to buy property, a lot of the time they’re looking at it more for a tax deduction, as a way of negatively gearing and reducing tax. Their strategy in actually retiring that debt down the track is an afterthought. If they then look at selling it and cashing in, they’ve got to be aware of the capital gain.”

Not that there’s anything necessarily wrong with paying CGT. “As I say to people, capital gains negate the negative gearing effect you had on the way,” Wight says. “You still made money.”

Part of it is about getting the right advice from the outset – and not just from mortgage advisers or property spruikers but also from accountants and financial planners.

Having a clear sense upfront of what you want is helpful. Wight says she sits down early on in the process with a client “and we work out what we’re trying to achieve,” she says. “If we’re trying to build a property portfolio, it’s important they understand it’s not just a matter of ‘he who’s got the most properties wins’, but he who has the most equity in their property assisting them to build wealth. You need to be able to reduce debt, while building equity, if you want to keep buying more properties.”

We asked Wight to model three scenarios: first-home buyer; interest-only loan versus principal and interest; and property for retirement. Here’s what she came up with:

Scenario one: First-home buyers

One common approach for people getting started in property is to buy a modest home to live in, with the intention of upgrading to a grander place later. It’s a straightforward ambition, and it usually goes like this: they’ll have debt on a property for 30 years and at the end of it all they’ll own it outright.

But it’s possible to be more ambitious than that, building equity in the home quickly with a view still to upgrading, but also to keeping the original property as an investment.

Wight cites the example of an initial $400,000, 30-year loan taken out at 7 per cent. Pay $3000 a month off the loan, rather than the required $2661 a month, and you’ll reduce the term to 21 years – saving a cool $182,254 in interest.

No first-home buyer is going to be able to make payments far above and beyond the required repayment every month, because there are a host of other demands on finances. But paying off as much as possible, as often as possible, helps reduce the owner-occupied home debt.

A redraw facility can be useful here, allowing borrowers to deposit extra money into the loan and withdraw it again when they need it.

However if the intention is to later convert the property to an investment, it’s vital to make those extra repayments into a 100 per cent offset account instead. This account and the loan offset each other – the more money is in the deposit account (think salary and savings for holidays, school fees), the less interest is charged on the loan.

“Over time, these extra deposits can significantly reduce interest payments and the life of the loan,” Wight says.

The offset account effect is mathematically the same as paying extra into the loan but with some distinct advantages. You retain full access to money in an offset account and as far as the Tax Office is concerned it doesn’t decrease your actual loan balance.

However if you pay down your loan balance and later access that money via a loan redraw facility, the Tax Office may take the view that you’re actually increasing your borrowings, in which case the higher interest charges as a result of the redraw might not be tax deductible. The property could become useless to you as an investment.

Build up purchasing power

Owner-occupied value	$450,000
Debt	$405,000 P&I*
Property value 5 years later	$521,672**
Debt 5 years later	$381,233
Money held in redraw/offset	$50,000
Available funds for next purchase	$138,271***
*Principal & interest @ 7% pa **based on 3% pa average growth ***@ LVR 90% (plus LMI)

Another first-home buyer approach is to do things the other way around: investment property first, then owner-occupied home. This buyer may purchase using benefits such as the first home owner grant, then rent the property out after a qualifying period (generally you have to live in the home for six of the first 12 months of ownership).

This strategy isn’t without drawbacks – chiefly, that once you sell a property you’ve used as an income-producing asset you’ll attract capital gains tax.

If you do it the other way around, as above, you can claim the CGT exemption on homes up to six years after moving out as long as you still nominate the property as your principal place of residence.

Once again, any extra repayments should be made into an offset account. Wight suggests waiting until the funds in that account, combined with your equity in the property, reduce the LVR (the amount borrowed as a ratio against the value of the property) to 20 per cent, so you won’t have to pay lenders’ mortgage insurance on the new property.

But don’t forget stamp duty.

Think, too, whether buying the owner-occupied property while keeping the investment one is really wise. “They need to consider if having a large amount owing on a non-income-producing asset is the right strategy and if they’d be better to sell the investment property and reduce the debt on the owner-occupied property,” Wight says.

Make an investment pay

First property value	$450,000
Debt	$405,000*
Property value 5 years later	$521,6702**
Debt 5 years later	$405,000
Money held in redraw/offset	$140,000
New property value (home)	$630,000
New property loan	$516,000***
Total security value	$1,151,672
Total loans	$921,000****
*interest only @ 7% pa **based on 3% pa average growth ***for purchase plus costs ****LVR 80% (plus LMI)
In a further 15 years’ time (current security values)
First property value	$981,519
Debt	$381,937
Second property value (home)	$812,747
Debt	$405,000
Total value of properties	$1,794,266
Total debt	$786,937

Interest-only v principal & interest

Many buyers of investment properties take out interest-only loans to keep repayments down. But should they?

Investors may be able to claim deductions on interest and maintenance costs, which is good. But “there does come a time when an investment property held over a long period would become positively geared”, Wight says, at which point the rent exceeds the interest charges and costs, and the tax deduction is no longer such a benefit.

It will depend on individual circumstances, but here’s an example.

How the interest compares

Investment property	$500,000
Interest-only loan	$500,000 30 yrs @ 7% pa
Principal & interest loan	$500,000 30 yrs @ 7% pa
Increased value	$1,213,631 30 yrs @ 3% pa
Sell property after 30 years
Cash from sale (IO)	$713,631
Total interest paid	$1,050,000
Cash from sale (P&I)	$1,213,631
Total interest paid	$697,544
Total savings in interest with P&I loan	$352,456

But Wight says professional tax advice is vital in assessing this scenario – so we got some. Peter Bembrick, tax partner at accountants and business advisers HLB Mann Judd Sydney, crunched those numbers for individuals on the 46.5 per cent and 31.5 per cent tax rates, for companies and for superannuation funds.

The results can be seen in the table. The conclusion: P&I results in a better nominal return regardless of the marginal tax rate, but the degree to which this is true depends on your tax band – and the investment has to be balanced with what else is in your portfolio.

“Tax deductions and marginal tax rates are relevant, as the tax deductibility of interest reduces the differential between interest-only and P&I loans,” Bembrick says.

But “all other things being equal, an interest-only loan will cost more than a P&I loan due to the higher interest paid, even after tax and regardless of the marginal tax rate”.

Bembrick has some key suggestions. Always pay off non-income-producing loans, such as the home mortgage, before investment loans. “If there are any non-income-producing loans owing then we would always recommend making extra principal repayments on those loans and keeping investment loans interest-only,” he says. “Therefore P&I only makes sense for investment loans once all private debt has first been repaid.”

He also counsels against seeing the P&I/interest-only decision on investment properties in isolation. “Investors need to consider the opportunity cost of funds that would be used to pay down investment loans and whether they could be better invested elsewhere.”

That should be part of your broader wealth management strategy. “If the alternative investment options are more attractive it may still be preferable to keep investment loans interest-only, especially once the tax deductibility is factored in.”

Ownership	Individual	Individual	Company	Super fund
Scenario 1 – P&I Loan, $
Total repayments	1,197,544.49	1,197,544.49	1,197,544.49	1,197,544.49
Present value of property	789,013.44	789,013.44	789,013.44	789,013.44
Total interest paid	697,544.49	697,544.49	697,544.49	697,544.49
Tax-adjusted interest	373,186.30	477,817.98	488,281.14	592,912.82
Cash from sale	1,213,631.24	1,213,631.24	1,213,631.24	1,213,631.24
Less cost base	(500,000.00)	(500,000.00)	(500,000.00)	(500,000.00)
Gross capital gain	713,631.24	713,631.24	713,631.24	713,631.24
Less tax	(165,919.26)	(112,396.92)	(214,089.37)	(53,522.34)
After tax gain	547,711.97	601,234.32	499,541.86	660,108.89
Less adjusted interest	(373,186.30)	(477,817.98)	(488,281.14)	(592,912.82)
Net gain on property	174,525.67	123,416.34	11,260.72	67,196.08
Present value (cost) less gain	614,487.77	665,597.10	777,752.72	721,817.36
Scenario 2 – interest-only loan, $
Total repayments	1,550,000.33	1,550,000.33	1,550,000.33	1,550,000.33
Present value of property	691,802.36	691,802.36	691,802.36	691,802.36
Total interest paid	1,050,000.00	1,050,000.00	1,050,000.00	1,050,000.00
Tax-adjusted interest	561,750.00	719,250.00	735,000.00	892,500.00
Cash from sale	1,213,631.24	1,213,631.24	1,213,631.24	1,213,631.24
Less cost base	(500,000.00)	(500,000.00)	(500,000.00)	(500,000.00)
Gross capital gain	713,631.24	713,631.24	713,631.24	713,631.24
Less Tax	(165,919.26)	(112,396.92)	(214,089.37)	(71,363.12)
After-tax capital gain	547,711.97	601,234.32	499,541.86	642,268.11
Less adjusted interest	(561,750.00)	(719,250.00)	(735,000.00)	(892,500.00)
Net gain on property	(14,038.03)	(118,015.68)	(235,458.14)	(250,231.89)
Present value (cost) less gain	705,840.39	809,818.05	927,260.50	942,034.25
Scenario 1 v Scenario 2, $
Nominal comparison (P&I less interest-only)	188,563.70	241,432.02	246,718.86	317,427.96
Present value comparison (P&I less interest-only)	91,352.62	144,220.95	149,507.78	220,216.89
Final outcome: All in favour of P&I

SCENARIO 3: Property for retirement

Wight costed three common property scenarios at this stage of life.

Marriage breakdown is regrettably frequent. As the former partners reach retirement they may have to remortgage the property, with one partner having to buy the home and pay a cash settlement to the other.

“I recently worked with a client who, at the age of 62, found herself in this situation,” Wight says.

The property was worth $650,000 and the client needed to refinance the existing mortgage, pay her former partner cash and have access to more cash for minor home improvements.

She took an interest-only loan for $363,000. “Her plan to retire the debt involved continuing in full-time work to the age of 68 – longer, if her health permitted – but then change to part-time work, which is an option in her profession,” Wight says.

Her daughter moved back home to live with her, assisting with loan repayments, and they agreed that after the repairs were done they would pay as much as possible each month to reduce the debt.

At retirement, superannuation money could be used to pay the debt down further, thus increasing equity in the property. At that point it would probably make sense to sell and downsize to a small property.

Benefit of paying down debt

Current property value	$650,000
Current debt	$363,000*
Property value after 8 years	$823,397**
Reduced debt	$325,000
Clear funds from sale of property	$498,397
*IO @ 7% pa **based on 3% pa average growth

A happier scenario involves borrowers looking to build wealth with investment property, creating a reliable income stream in retirement.

People do, after all, like the visible, tactile nature of bricks and mortar.

For this strategy to work the property has to become self-funding and the loan amounts must reduce, to provide income later. Wight says clients often buy a mixture of properties in regional and capital cities.

Capital cities provide the best capital growth and rents but require high investment; regional centres are cheaper and become self-funding more quickly.

In this scenario, the investor plans to downsize to a smaller home worth $750,000, pay off all debt and use the rent as income in retirement.

Income-producing asset

Owner-occupier home (no debt)	$1,300,000
Regional property 1 (no debt)	$250,000
Rent return (per week)	$250
Regional property 2	$300,000
Debt	$120,000
Rent return (per week)	$270
Capital city property	$550,000
Debt	$300,000
Rent return (per week)	$530
Total property value	$2,400,000
Total debt	$420,000
Total rent return (per week)	$1050

Another common approach is to hold investment property until retirement, with a view to selling at that time to clear the debts. Once that’s done, the remaining proceeds from the sale can go into super, or another investment strategy (see “Talking tax”).

The numbers are the same as above but the rent will obviously stop.

Optimise gains for new strategy

Owner-occupier home (no debt)	$1,300,000
Regional property 1 (no debt)	$250,000
Rent return (per week)	$250
Regional property 2	$300,000
Debt	$120,000
Rent return (per week)	$270
Capital city property	$550,000
Debt	$300,000
Rent return (per week)	$530
Total property value	$2,400,000
Total debt	$420,000
Total rent return (per week)	$1050

“In this scenario, the borrower can sell either their city property or both regional properties to clear their debts and have funds to invest, while still receiving rental income on the remaining properties,” Wight says.