House Swapping

The fundamental principle is that you can claim a tax deduction for interest only if the purpose of the loan is to buy income-producing assets such as property or shares. This is why you can’t claim interest on your home loan, and why you can claim it on a loan to buy an investment property. Often, people who have paid off their home decide to keep it as a rental and borrow against it to upgrade to a better home and try to claim the interest on the new loan as a tax deduction. It’s not, as the purpose is to buy a home to live in. But a loan can change character. If you move out of your residence and rent it out, all out goings including interest are tax deductible from the moment the property is available for rent and if you own a rental property and move into it, outgoings cease to be deductible as the property has become your residence. The fact that a loan can change character provides a window of opportunity for friends who wish to get into the housing market, or for those who need help with their mortgage repayments. Suppose the Smiths want to buy their first home for $400,000. With $40,00 deposit and first home owners’ grant, they would have to take out a loan of $370,000 on which the interest alone would be $2775 a month. Costs of ownership such as rates and maintenance would add another $170 a month – their total payments will be $892 a week.
Now think about their friends the Browns who buy a similar $400,000 property for investment and rent it out for $350 a week. They take an interest-only loan of $370,000 which will cost $2775 a month in interest, and they are still up for $170 a month in maintenance. Because the property is for investment, these costs will be tax deductible. Let’s assume the building will generate $5000 a year in depreciation and building allowances which they can claim on their tax, even though they do not require an immediate outlay of money.

The difference between the net rent and the outgoings will create a cash shortfall of $330 per week but their total loss for tax purposes will be $22,160 a year when the depreciation allowances are taken into account.

If they are in the 31.5 per cent tax bracket, this will create a tax refund of $6980, which means the total shortfall will be only $291 a week. Notice how the system is skewed toward the investor and against the owner.
Here’s the clever bit – if they both wanted to achieve their goal of home ownership, they could do a swap and rent each other’s homes for $350 a week and both enjoy the tax savings due to negative gearing.
First home buyers who wish to adopt this strategy should ensure they move into the house at the outset and stay there for at least six months. This will ensure eligibility for the first home owners grant and will also exempt the property from capital gains tax for up to six years provided they do not claim any other house as their residence in that time. As long as they both return to their own homes before the six years is up, all capital gains will be tax-free even though they’ve enjoyed the benefits of the tax deductibility of all the outgoings including interest.