Hi all (& apologies for the really looooong post!)
Just rereading Ch 8 and am a bit stuck on some of the accounting explanations used. Eg:
1. P107 – ‘be very careful not to confuse cashflow received and cashflow paid with the accounting terms ‘income’ and ‘expense’.
How do accountants define these terms – they seem to be very different to what I’d understand by them?
2. P108-110 – the distinction between ‘what accountants measure’ and ‘what investors measure’ (p107-110).
What are some examples where there is different treatment of the figures?
Now some questions on tax
3. I have a spreadsheet that documents IP income and expenses. This seems to be similar to Steve’s suggested method of calculating.
This might look like this:
INCOME
Rent (pa): $8000 (assume 48 wks occ)
EXPENSES
Loan repayments (P&I): $4700
Body Corporate: $500
Rates & Water: $500
Property Management: $800
Insurance: $500
Maintenance allowance: $500Total Expenses = $7500
* Cashflow surplus = $500pa (before tax) [property is genuinely cf positive before tax, though the cash on cash return isn’t great]
TAX DEDUCTIONS (assuming 30% marginal rate)
Interest: $1000 (assume int = 1/3 loan payments)
Other expenses: $1000
Building Dep: $300* Overall surplus (after tax): $2800
Now I’m aware that building depreciation changes the capital cost of your building, so if you claim it you will have to pay more capital gains tax later on if you sell.
But surely tax deferred is almost as good as tax avoided? Isn’t this effectively an interest-free loan from the govt, and one that assists cashflow now? And if you don’t sell you don’t need to pay it back?
Then there are the other management expenses for which deductions can be claimed.
I understand that you can only claim deductions if you’re paying tax, but what’s wrong with counting them while you’re still working and paying tax, bearing in mind that when you stop working you can’t rely on them to continue? It’s still real money coming in, which can be used to reduce debt before you retire, or even to buy more (hopefully more positive) property. For this reason, I’d still include them on my spreadsheet.
4. Should we make a distinction between the proportion of a loan that is interest and that which reduces the principal?
Though I haven’t myself (as both must be paid and they’re both part of the cost of buying a place), as the interest component falls, though your tax deductions fall, and you cashflow is decreasing, your position is improving as more of the repayments are boosting equity, so can be used to buy more property.
Peter
Hi PeterP, I can see a lot of members have read your post and nobody has replied to it yet, so I’ll have a go.
Steve was saying that net cashflow is simply the difference between casflow received, ie rent and cashflow paid, which includes principal loan component as well as interst. He doesn’t include “cashless” deductions like depreciation (although it does result in cash in your hand from the taxman!) Clearly you need to show different figures (between expenses and cashflow paid) on your tax return although casflow received and income are probably similar.Expenses include depreciation and exclude principal repayment which are the main two differences I believe.
I agree with you about the deferred tax aspect. Depreciation allowance is in todays dollars, tax you have to pay on the resulting increase in your capital gain may be in 25+ year’s time dollars, plus you only pay tax on half of that gain.
As I’ve posted elsewhere, however, the bank doesn’t take the depreciation in to account when they assess your loan servicing ratio, plus it starts to peter out after a few years. If your rent has gone up, and your interest component has decreased then hopefully all will be fine.
The big bugbear with reliance on depreciation is of course, that it gets pushed down progressively into lower tax brackets as you own more properties (or the government brings in gst and lifts all the lower brackets into your deduction level!). It makes that novated lease on your car a bit less attractive as well!
In regard to principal payment, a lot of investors consider that P&I loans drastically limit the quantity of properties you can acquire. They advocate interest only loans. Obiously it is nice to reduce the principal in case of interst rate hikes etc, but from a purely mathematical point of view, the investment you make in paying off the principal is only equivalent to a return equal to your interest you would have paid on that part of the principal, less the tax deduction benefit. eg you make a $1000 principal payment on a loan at 6%, you will save $60 in interest after a year, but that was tax deductible anyway, and you would only save $30.90 pa if you are in the 48.5% bracket. ie its only a 3% (after tax) investment. I prefer to leave any surplus cash in my 100% offset account. Its basically the same maths, but its more readily available if I need it. If its just there for future equity then there’s not much differenece between the two of course.Thanks Doogs!
It seems as if I’m already calculating it right by including the full principal repayment in my figures.
Also a few days ago I rejigged my spreadsheet to include (1) before tax cash flow (2) after tax cash flow and (3) cash on cash return.
I should probably learn more about accounting sometime, but it might just confuse a simple mind like myself!
I’ll claim depreciation, as it can help build equity faster (on the early purchases), but won’t rely on it.
As for interest only loans, there are differing views, but can appreciate the benefits especially if you were wanting to pay off a (non-deductible) PPOR mortgage.
Despite the reduced tax deductions and the higher payments, I followed a conservative approach (substantial deposit, P&I loan and accelerated payments) for the first property. My reasoning is that I get equity in it quickly and can redraw funds to obtain deposits for future purchases.
As these future purchases would also be CF+, surplus funds would be put back into the loan for the first property. As there are now two cashflow surpluses topping up that loan, equity would be growing faster than before, making the purchase of a third IP possible sooner.
However I see a limit to this – looking at loan payment versus term tables shows that making small additional payments can shorten the loan from (say) 30 to 10 years, but once you get below 10 years, you’re not saving much interest and I’d rather lash out and buy another IP!
As to whether future IPs should be on IO loans is an open question for me (especially not being in the top tax bracket). Yes you could service larger loans if paying IO and all your payments would be deductible. But I also like the idea of building equity as well as income and keeping LVR under control, maybe by investing an equity component into a sinking fund. Whittaker/Resnik’s ‘Borrowing to Invest’ talks about this and I should re-read it.
Peter
Principal payments are essentially just a 3% after tax investment, no matter how you look at them. It doesn’t really matter how much is left owing, you are still investing your money at 3%. The bank probably views cash and equity as equal when assessing us, so If we pay off principal, or keep it aside in an offset account, then it probably carries equal weight provided the cash is going towards the next property.
The essential difference is probably psychological: It feels much better to pay off principal, and the cash sitting in your offset account is just too easy to squander on a new Monaro (eg)!Just another question about your book Steve: In your appendix B about negative gearing you give the example of a property that costs $230,000 including closing costs, with a $207,000 loan and $23,000 deposit. It sells for $322,000 with a paper gain of $92,000, which will be reduced by selling costs of $14,880.
In your table on P356 however, your acquisition cost has changed from $230k to $250k so assuming this is just a transcription error, your gross capital gain should be $87,120 which gives an after tax gain of $65993 (with 48.5% tax). This is then reduced by your 5 years negative casflow of $10,065 to result in a net gain of $55,928
What I don’t understand, however, is why you deducted the $23,000 deposit from the net capital gain. Surely it would have been returned as part of your original acquitition cost, ie out of the 322k sale price, you pay the bank back its $207k and the agent & legals $14,880 which leaves your $23k deposit plus $87,120 gross capital gain.
As far as I can work out, you should have a net gain of $55,928 from your $23k deposit to give a total cash on cash return of 243%, or 48.6% pa. which is a bit better than the 66.1% and 13.22% resp in your example.
Perhaps I am missing something though.
JCome on Steve, or anyone who has read the book and knows how to use a calculator, can you please explain the (suspect) maths in Appendix B.
Thanks, J.Hi All,
Thanks for stimulating the brain cells [|)]
I also felt that there was some suspect maths involved in the appendix but put it down to typing error rather than a change in the transaction. I must admit though I read the book in one sitting and late at night and didn’t bother to check the maths all that carefully. I was more interested in the principals than the details.[
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your acquisition cost has changed from $230k to $250k so assuming this is just a transcription error, your gross capital gain should be $87,120I think you mean $77120, this slightly changes your later figures.
The original $23K is subtracted from the gain as it isn’t gain – it’s your original investment. This is a cash on cash return, so you’re looking for how much return your original cash contribution ($23K) has given you.
I calculate a net gain of $25353, which gives a cash on cash return of 110% or 22%pa. Still better than the figures in the book.
Rod.
Dang, I must have missed the “1” on the calculator!
But Rod, surely you end up with $71,353 in your bank account after all the dust has settled, ie $23,000 + $48353, which is 48353/23000 CoCR or 210%. The original deposit is part of the purchase price, and you get that back, plus the net gain.
JHi,
Thanks for your post.
I’ll have a look at this and get back to you soon.
Cheers,
Steve McKnight
**********
Remember that success comes from doing things differently.
**********Steve McKnight | PropertyInvesting.com Pty Ltd | CEO
https://www.propertyinvesting.comSuccess comes from doing things differently
But Rod, surely you end up with $71,353 in your bank account after all the dust has settled,I don’t believe so.
My calcs are:
sale price ($322K) – purchase price ($230K) = $92K
subtracting costs ($14880) leaves $77120.
subtract tax (77120*0.5*0.485) leaves $58418
This is the amount which will end up in your bank account.
To get your overall return you then subtract the contribution over the years ($10065) which leaves
$48353.So you’ve actually made $25353 as the other $23K is your original funds. The return on investment is 25353/23000 which is 110%.
Don’t know if I’ve expressed this very well.
rod.
Rod, your loan was 207k, not 230k, so you get 23k back in your bank account when you repay the loan.
JSorry doogs,
You’re right.
I must learn to think before I type.
Rod.
Hey I can’t even push my calculator buttons properly. Congrats on the 100, but that just means you’re spending too much time here and not doing your real job, like me! dang addictive forum! We’ll have to start another forum for forum addicts! (already done on irc of course).
Hi again,
OK – I’ve had a chance to check out the figures and I agree doogs that there is an error.
For what it is worth, the purchase price in one earlier addition was $250,000, but it paid too negative a spin so I adjusted it back to $230,000. Anyway, this seemed to have slipped through – my fault.
Anyway, the figures should read:
Likely Profit On Sale Of John’s Property
Sales Price $322,000
Agent’s commission @4%($12,880)
Legals etc. ($2,000)
Acquisition Cost ($230,000)
Gross Capital Gain $77,120
50% Exemption ($38,560)
Taxable portion $38,560
Income Tax at 48.5% ($18,702)
After Tax Profit $19,858Add Tax Free Portion $38,560
Total After Tax Gain $58,418
Five Years (After Tax) Negative Cashflow ($10,065)
Nett Gain $48,353My point here is that John’s paper gain of $92,000 is quickly eroded back to $48,353 after adjusting for tax and the negative cashflow.
It is wise to remember that tax is only payable if you sell, and that the impact of that tax can be significant.
Thanks for bringing this to my attention.
Regards,
Steve McKnight
Steve McKnight
**********
Remember that success comes from doing things differently.
**********Steve McKnight | PropertyInvesting.com Pty Ltd | CEO
https://www.propertyinvesting.comSuccess comes from doing things differently
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