It’s rare for a first home to become your forever home, especially in today’s property market. Most buyers treat their first home as a stepping stone toward their dream home—whether it’s a small apartment in the city or a place in a less than ideal suburb.
For many first-time homebuyers, this approach makes sense and is often a smart financial move. But once you’re ready for that next home, the question arises: Should you keep the first property as an investment, or sell it and move on?
While the idea of turning your first home into an investment property is tempting, this strategy carries a financial trap that many homeowners overlook. This article isn’t here to tell you not to go down this path, but to raise awareness of the potential downsides.
Where to find a deposit?
When upgrading a home, many couples find that their increased borrowing capacity comes from a rise in household income, not necessarily from saving a large cash deposit. But even with a bigger borrowing capacity, the lack of deposit is often a problem.
Those looking to step up into their next family home may find they are not constrained by their borrowing capacity, instead by their level of deposit.
There are two potential solutions to this problem. The first is to sell the existing home and use the cash to fund the deposit. This is the most obvious option and one taken by many people.
But what if you want to keep the property as an investment?
This option would involve utilising any additional equity built up in your existing home as security against the purchase of the new property.
Provided you have enough equity built up in your existing home, you may even be able to purchase your new home without using any cash savings as a deposit. This is through a process called cross-securitisation, which can have some unfortunate consequences in the future.
Cross-securitisation (also called cross-collateralisation) is the process of using a single property to secure multiple loans. In our example, this would involve using the equity in your existing home to secure a loan for the deposit for your new home.
Example
Say your current home is worth $1 million, with a $400k loan against it, leaving you with $600k in equity. You’ve done well financially and now want to upgrade to a new home worth $2 million, but you don’t have enough cash for the $400k deposit needed to avoid Lenders Mortgage Insurance (LMI).
Your mortgage broker will have a very convenient solution for you. Why not use the extra equity in your current home to make up for the additional $400k? No LMI will be payable, and you get to keep your new investment property! Sounds like a no brainer. Better still, your mortgage broker gets another $400k loan to write, which means more commission for them.
After completion, your loan structure would look something like this:
All goes well, you move into the new property and start renting out the old one. After a year, tax time comes around and you’re excited to get the interest cost deductions from the loans against your investment property.
You’ve now got $800k in debt secured against your investment property, so surely you get to claim all of the interest related to this debt?
Unfortunately not, and at this point it’s far too late to unwind the trap that you set yourself.
The Tax Trap
Contrary to what you might expect, the tax deductibility of a loan isn’t determined by the asset that secures it. Instead, it depends on the purpose of the borrowed funds.
In our example, the only deductible loan is the original $400k used to buy the old home (now the investment property), because it was directly tied to that purchase. The additional $400k, even though secured against the investment property, was used to buy the new home, which doesn’t generate income and therefore isn’t tax deductible.
So, despite having $2.4 million in total debt, only $400k is deductible. Worse still, there’s no way to unwind this without selling the investment property and restructuring the loans from scratch. Not ideal.
But what if we did things differently from the start?
Selling the home before upgrading
What if instead you sold the existing home before re-buying, how would this affect your loan structure?
After paying off the remaining $400k loan, you would be left with $600k cash ready to be used as a deposit for the new home, requiring a $1.4m loan for the purchase.
But what about the investment property?
Your new home would have $200k in usable equity (up to an 80% loan-to-value ratio) for a new property. You could borrow against this equity for the deposit for your new investment property, with the remainder financed against that new property. This would result in a total level of borrowing of $1m (100%) for that new property.
How would this new structure look?
This structure leaves you with $1 million in deductible debt on the new investment property—a significant improvement over the original $400k. At a 6% interest rate, this difference could mean the difference between $24,000 and $60,000 in annual tax deductions.
Considerations
This strategy isn’t without its drawbacks, though. The main downside is stamp duty—you’d need to pay it again when buying the new investment property. For a $1 million property in NSW, this could be around $40k. However, with the increase in tax deductions, this upfront cost will likely be worth paying over time.
Another potential issue is market timing. If property prices rise between selling your first home and buying the investment, you might find it harder to buy an equivalent property with the same budget.
However, when we balance these potential issues against the very real benefits of this strategy, it’s hard to justify a scenario in which one should keep their old home as an investment property.
Additional benefits not previously mentioned include the flexibility to select a property that is better suited for investment purposes. What works as a home doesn’t necessarily make a great investment. You could even consider diversifying—perhaps splitting the funds between two investment properties, or a property and an ETF portfolio.
You might even be able to borrow additional funds for the purchase of the investment property, as lenders often take total deductibility into account when determining borrowing capacity.
While this strategy theoretically offers a more efficient way to upgrade your home while maintaining an investment property, remember that theory doesn’t always align with practice. You should review your own personal situation with an appropriately qualified professional before making a decision.
