Should you keep your first home as a rental when upgrading? - Nadine Higgins

Keep or sell: The real cost of holding your first home as a rental. Photo / 123RF

THE FACTS

• Reserve Bank rules mean most borrowers need to have at least a 30% deposit – or 30% equity – in an “existing” property.
• Debt interest on a new home isn’t tax-deductible, unlike investment property debt.
• Consider Healthy Homes standards and financial risks of unforeseen bills when deciding to keep a property.

Many of my clients over the past few years have been based outside of Auckland, in places where – generally – mortgage debt levels are less onerous. It led to some interesting questions about the best path forward.

One which cropped up repeatedly was whether it makes sense to hold on to your first home, when trading up to your second or “forever” home.

(For Auckland clients, high house prices and debt levels generally meant it was a non-starter.)

But for those in other regions, the rationale was either wanting to become a landlord with a property that had served them well (not paying real estate agent’s fees was a bonus); or it was based on sentimentality – not wanting to let go of the place where their kids were born or their dog was buried.

Let’s try to set the second reason aside – because your eyes will be watery for a different reason if you later find it was a disastrous financial decision.

So, let’s instead work through some of the things to consider as to whether it makes financial sense.

Taxing considerations

It might not be your first thought when you’re doing your sums, but tax is something worth considering in this situation.

That’s because you will likely be borrowing more to secure your next property, and that may result in the bulk of your debt being against that new property – your new home – with less debt against the original property – now your investment property.

Debt against your home is not tax deductible, whereas debt against an investment property is (side note: deductibility is being phased back in over multiple tax years). If the result is rental income outstrips expenses, you can end up owing tax on that property, while being highly indebted on your home.

If you’ve secured debt against your original home to buy the new one, beware – that doesn’t necessarily make it tax deductible.

Catriona Knapp, director of Future Focussed Accountants, says: “Some fall into the trap of thinking that if they draw down debt and secure it over the rental property then the interest on this debt can be claimed. This is not necessarily the case as the IRD look at the intention of the debt not what it is secured over. So, if the intention of the debt was to purchase a new (private) home, then the interest on that debt cannot be claimed even if it is secured over the rental property.”

It’s worth seeing an accountant, as there are options to structure things more efficiently, for example selling the property into a new entity.

Knapp says: “The new entity can draw down debt equivalent to the market value of the property at the time. This provides not only a tax benefit as the maximum amount of debt now relates to the rental property but also can protect their personal assets from risk as the rental business is then carried out by a separate legal entity.”

You do also need to take care here, as selling the property into a new entity means the “bright-line” tax clock starts – so, if you sell the property within two years, any gain may be liable for tax on any gain.

Efficient use of your capital

What made it a great home doesn’t necessarily make a great investment. Perhaps you’ve extracted the best gain that property has to offer, and you should bank it and move on. Perhaps its cashflow is too weak to stack up as a rental.

Another consideration is Reserve Bank loan-to-value ratio (LVR) rules mean most borrowers need to have at least a 30% deposit – or 30% equity – in an “existing” property (i.e. not a new build) that is not their primary residence.

That’s where many come unstuck, according to broker at Hastie Mortgages, Campbell Hastie. “The lower LVR threshold for existing property being used as a rental is what stops most people keeping their first house when trying to upgrade to something newer/bigger/better. There hasn’t been a lot of capital gain in recent years which also makes it harder to get past that LVR threshold.”

While holding on to an “existing” property requires 30% equity, a “new” property usually only requires 20%. The question you need to answer is whether you could deploy the difference more effectively.

Up to scratch

Rental properties must meet Healthy Homes standards, but it’s entirely possible when it was your home it did not meet that standard – I know my first home definitely did not! In determining whether you hold on to it, ensure you establish whether upgrades are required to meet the heating, insulation and ventilation requirements, and what that might cost.

If your intention is to hold on to your rental property for the long term, one of the biggest risks to that is large, unforeseen bills. If the roof needed replacing, could you stump up for it without putting major pressure on your financial situation, or having to sell in haste? That is, in my opinion, one of the major selling points of new builds – you should have a window of time where major work isn’t required, and potentially a build guarantee to fall back on if something’s faulty.

There is no singular “right” answer – there is what is right for your circumstances. But property decisions are among the biggest financial decisions we make so it pays to think through the consequences, get good advice – and set sentimentality aside.

Sign up to Herald Premium Editor’s Picks, delivered straight to your inbox every Friday. Editor-in-Chief Murray Kirkness picks the week’s best features, interviews and investigations. Sign up for Herald Premium here.