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What should you know about renting out a property with a mortgage?
Buying property for the sole purpose of renting it out is fairly common and can be a steady source of income. But what if you decide to rent out your owner-occupied property and move elsewhere?
There could be several reasons why you might want to move houses. You may be shifting interstate or overseas for work, or you may have found another property that suits your needs better. Irrespective of why you want to shift out, renting out an owner-occupied property will generally require you to look at the tax aspect and whether you wish to return to the house in future.
Your primary residence is exempt from Capital Gains Tax (CGT), but this could change if you convert it into an investment property to earn rental income. However, the 'six-year rule' allows you to shift elsewhere and earn rental income from your primary residence if you return to live in it within six years.
Things get a little more complicated if you have a mortgage owing on the house because lenders offer different financing options for owner-occupied and investment properties.
If you're still making repayments on your home, it's worth checking with your lender whether the terms of the mortgage allow you to lease or vacate the property. You could also ask a mortgage broker to help you understand any specific restrictions or rules regarding the property mentioned in the loan contract.
What do you need to consider before renting out a home with a mortgage?
Turning your current residence into a rental property could have some potential benefits, such as helping you build an income source and taking advantage of tax deductions reserved for property investors. However, there are also downsides to consider, such as restructuring your home loan if requested by the lender and making the house tenant-worthy.
If you've decided to convert your house into an investment property, the first thing you should do is read through the loan documents for your home or contact your lender to find out if there are any limits or restrictions to how you can use the property. Your agreement may also mention that you must seek the lender's consent before vacating or leasing the property.
Depending on the terms of your loan, the approval may be subject to you paying a higher interest rate or fees on the loan or refinancing your owner-occupied loan to an investment loan.
As lenders typically consider investment properties to be riskier than owner-occupied properties, the interest rate and fees on an investment loan are likely higher than what you were paying on an owner-occupied loan.
Here's what you can expect if you decide to switch to an investment loan:
Additional security
Some lenders might ask you to pay more security when refinancing to an investment loan. With property values going down at the moment, it's also possible that your ownership percentage (or equity) in the house has reduced.
If you owe more than 80 per cent of the property's value, you may find yourself imprisoned by your mortgage. You may have to wait it out and build some equity before qualifying for a home loan refinance. Alternatively, you'll need to pay for Lender’s Mortgage Insurance, which could increase the cost of the loan to you.
Higher monthly repayments
Your interest rate and the total cost of the loan to you are likely to increase. Even though you expect the rental income to cover some of these costs, there may be months when your house is going to be vacant.
It could be smart to calculate your monthly repayments and check whether you can afford them even when you don't have any rental income. When crunching the numbers, remember to consider the expense of your new living arrangement, too.
Flexible payment terms
Even though an investment loan is likely to cost you more than an owner-occupied loan, it may also include features and benefits that appeal to investors, such as improved flexibility or the option to make interest-only repayments for a limited time.
If you're planning to buy another house, making interest-only payments on your current home may help you manage your cash flow in the short term. While this is a route many investors take to build their property portfolio, it's important to remember that your monthly repayments will likely jump at the end of the interest-only period. If you don't plan your finances wisely, you might find yourself trapped with a higher monthly payment you can't afford.
When planned well, choosing to make interest-only repayments for a set period (usually five years) may help you avoid out-of-pocket repayments without affecting tax deductions. Your loan would take longer to repay, but you could benefit from a sharper rise in property value over the loan term, ensuring that you make a tidy profit when you choose to sell the property or use its equity to buy another property.
Tax savings
When you take out a mortgage as an investor rather than an owner-occupier, you can immediately start claiming a tax deduction on the interest you pay on the mortgage. You could also claim deductions for any home improvements you undertake that positively impact the property's value.
Also, if the rental income doesn't cover these deductible expenses, your investment property is negatively geared, making you a loss that brings down your overall tax liability. If you are still making a loss after factoring in your other sources of income, you could also carry forward your loss and declare it on future tax returns.
However, from the Australian Tax Office's (ATO's) perspective, claiming these deductions can require checking the time your property was genuinely available for rent and what portion of it was rented out. Also, if you used some of the investment money for personal expenses, you may have to calculate the percentage used for investment and claim deductions accordingly.
Effectively, you only get a tax deduction on expenses that were incurred in the process of earning rental income. Consider speaking to your accountant about claiming deductions and filing your tax returns accordingly. An accountant can also help you keep track of your rental-related expenditure rather than just prepare your tax return.
Besides interest rates and taxes, it also helps to check the rental potential of your house before you decide to convert it into an investment property. It's possible to overestimate the desirability of your home because you are attached to it. Instead of guessing the rental potential of your house, it could be helpful to research comparable properties to get a realistic view.
You should also ensure your home is ready to be rented out to tenants. Some states and territories have specific minimum living requirements that rental properties must meet. Even if you love your house, it's possible it doesn't meet some of these requirements, and you'll have to spend some money to make it compliant for rental. You can speak with a real estate agent or a property manager to learn more about the necessary compliance requirements for rental properties in your area.
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Product database updated 25 Dec, 2024