Low doc loans - have I missed something?

[SuperDad]

Hi all,

I had a good week last week, or at least I think that I did.

My broker got me pre-approved for my first lot of lo-doc lending. While I might not need to use it, it seems good to have this finance as a backup if standard lending doesn't come through (due to serviceability).

But am I missing something, because the finance seems too good to be true? Here's my situation:

I currently have one property, which has an after renovations value (ARV) that is $110K higher than the purchase price plus renovations. Bank A, which holds security over the property, has agreed to lend to 90% of the ARV. So I will have $100K sitting in a revolving credit/LOC facility in a day or two.

Lender B will loan up to 70% on a lo-doc loan - I have pre-approval for this facility. (I can go to 80% with Lender B after 1 year of self employment.) My broker confirmed that I could use the $110K equity increase in my property as income, for the purposes of the income declaration for Lender B. Keep in mind that the $110K equity increase seems to be tax-free income. It is tax free because the property that generated that "income" is a buy-and-hold. I did not have to sell the property to access that income, unlike with a trade.

So it seems to me that I am getting "two bites of the cherry", so to speak. I can release the increased equity for Property 1 to use as a deposit on more property, and it seems that that released equity is not taxable. Further, I can declare that equity as "income" for the purpose of a obtaining further finance.

Theoretically, so long as I make the right purchases, there is no stopping my investing. All I need to do is make sure that: (1) my property purchases are CF neutral, such that rental income covers interest repayments, rates, insurances and maintenance, and (2) that the ARV on each property purchase enables me to roll out a deposit for the next property. So say that my next purchase is as follows:

Purchase price: $280K
Renovations: $10K
ARV: $350K

On a lo-doc 70% loan, I will need to have an $84K deposit, plus $10K to cover reno costs. This will leave me borrowing $196K from Lender B on lo-doc. Then, after renovations, I can borrow up to 70% of the ARV on lo-doc, declaring the $60K equity increase as my income. (If I do this in the same year as my first property, I can add the $60K to the $110K "income" from my first property.) 70% of the ARV of $350K = $245K. Less the $196K already borrowed from Lender B, this frees up $49K. Not quite enough for another 30% deposit, but money nonetheless. After one year of self-employment, I can then borrow up to 80% on lo-doc. All of a sudden, the calculations swing in my favour. I can now borrow up to $280K against Property 2, which frees up $84K. I'm house hunting again. From that point on, there seems to be no stopping (so long as I get the ratio of purchase price to ARV correct, and the properties are CF neutral).

The ball is in my court. No more do I have to worry about hitting a "serviceability wall", due to lenders only taking into account 75% of rental income. As long as I know that the properties are at least CF neutral, I can get the money due to (honestly) declaring the equity increases I create through renovations and wise purchasing. The absolute beauty of this strategy seems to be that I don't need to worry about "advanced" strategies like trading or LO/SLO's. I don't need to sell properties at a profit, and pay income tax on the gains. I can simply access those gains tax free. (The downside is that one needs to run at a high LVR. But I don't see a big problem with this if one has a long-term horizon, and the properties can pay their own way. I could run a high LVR over my portfolio for 5 years, and then sit back and wait for capital gains to reduce the LVR.)

Again, have I missed something? Or am I waking up to the world of finance? Is there anyone else out there who is using lo-doc lending in this way?

Apart from the high LVR, does anyone know of dangers associated with what I suggest?

Paul.

[Monid]

Hmm seems too good to be true.

Some possibilities.

1. Your broker could be wrong. I think personally he is, income isn't borrowed. You have equity, not income.

2. Low doc lenders may be smaller fry than the traditional lenders, this may make them more vulnerable to changes in the market. This might intensify the risks involved in a high LVR, especially because they may have less concern than the major banks have for avoiding the mortagee auctions.

3. The more properties you have the more potential repair costs you might need to cover... The more capital you need to have sitting by waiting for the worst to happen, so you at least need to keep a fairly serious wedge available for emergencies.

4. Don't some lowdoc loans have either higher interest rates and or caps? Either could make it harder to find an appropriate property.

Can't think of anything else just yet, so lets see what others have to say.

David

[CJ]

- Interest rates are higher than normal lending I think? How much higher is the low doc rate for you 1%?

- At all times, the the banks have security of the property and are never lending more than 90% for bank 1 and 70-80% for low doc bank. Therefore if you default, they still take your houses.

So all is well (except teh higher interest rate) with low doc loans while you can pay them, in the end, they still have sufficient security if you fail.

[Josko]

I have an issue with the broker saying you can state your income to be the equity in the 1st IP, yes you can state the 110k is income, but you would need to use a vehicle like cash bonds (I think), the issue then is that you have used this up in the bond and is not available to be used as a deposit.

Can you clarify what your broker means, it could be one of those slight of hands that is an ethical quandary and a business finance reality.

[SuperDad]

I have an issue with the broker saying you can state your income to be the equity in the 1st IP, yes you can state the 110k is income, but you would need to use a vehicle like cash bonds (I think), the issue then is that you have used this up in the bond and is not available to be used as a deposit.

Sorry Josko, I've lost you here. What do you mean when you say that I would "need to use a vehilce like cash bonds"?

1. Your broker could be wrong. I think personally he is, income isn't borrowed. You have equity, not income.

I see things a little differently. The equity is income, as it was created (earned) by buying well, renovating, and finding good tenants. That income is now available to be spent, by the trust.

Hi CJ - yes, the lo-doc has a 1% loading. Once I've been in business two years, I should be able to access lo-doc products at standard rates.

Paul.

[Josko]

Sorry Josko, I've lost you here. What do you mean when you say that I would "need to use a vehilce like cash bonds"

A cash bond can be used to increase your income on the loan application, essentially you can convert the existing equity into cash flow by purchasing a cash bond from an insurance company. A cash bond would then be repaid to you including interest over a nominated term, you are then able to state that your income is job income + rental income + cash bond income.

So you are using the equity to increase your servicing levels.

I see things a little differently. The equity is income, as it was created (earned) by buying well, renovating, and finding good tenants. That income is now available to be spent, by the trust.

This is a low doc loan so the definition of income can be configured, as you are able to use the trust to distribute the equity as income, though it is questionable if it can be determined to be annual income.

I am sure I don’t need to point out the ethical issue Paul, however if you state that the equity will be utilised as income and then utilise the equity as a deposit for the next purchase, as you clearly would need to do, then questions over the purity of that transaction can arise.

I am not saying it is impossible, but I see a structured intention that many in business overlook when thinking about integrity and ethics.

I await you perspective on this.

Cheers,

[captaincrab]

If you treat the equity as income, then you are deemed to be trading and hence you will pay tax.Using the equity as equity for your next purchase is different.
Be aware that when you "declare" your income, that you are making a statutary declaration. Feedback from Australia where lo-docs are prevalent is that the Inland Revenue are serving Orders for Discovery on banks like Bluestone, making them reveal what "income" people are decalring and then comparing that to what they have paid tax on. Smart of the IRd actually because they get get either for not paying tax or you have made a false declaration to the bank...Not sure where the cash bonds come into this one? You could obtain a Deposit Bond against the equity of the asset and then on settlement leverage against the value on a lo-docs loan.

[Monid]

Be aware that when you "declare" your income, that you are making a statutary declaration. Feedback from Australia where lo-docs are prevalent is that the Inland Revenue are serving Orders for Discovery on banks like Bluestone, making them reveal what "income" people are decalring and then comparing that to what they have paid tax on. Smart of the IRd actually because they get get either for not paying tax or you have made a false declaration to the bank...

Ouch its not a cake... its a tax poison pill. Can anyone confirm this in the NZ context?

David

[SuperDad]

David,

Ouch is right!

I'll check this out, and let you know what I find.

If you treat the equity as income, then you are deemed to be trading and hence you will pay tax. Using the equity as equity for your next purchase is different.

Are you sure this is the case CC? The equity/income hasn't been generated by a sale, so I'm not trading. The equity has been freed up by way of a LOC, and will be used for the next purchase. The only problem, if there is one, lies in treating the equity increase as income. And I can see how this could be a problem.

Paul.

[SuperDad]

Hi all,

I've just checked with my mortgage broker and, to the best of his knowledge, there is not problem declaring the equity increase in a property as income. The income hasn't been generated by disposing of the property, so it is not taxable as per section CB5 of the Income Tax Act 2004.

I can see the problem, though. If the IRD decide that these declarations constitute declarations of assessable income, then one could be liable to pay tax on that declared income. I will need to check with my accountant as to whether the "income" created by equity increases is assessable income, or is exempt or excluded income.

Food for thought, though. I'm glad I asked this question - getting the right answer now could save a lot of pain later on.

Paul.

[FatBelly]

My interpretation would be simply that if it is income, then you would be required to pay tax on it - just like anyone or any entity is required to do for anything referred to as 'income'.

As I DONT think you are required to pay tax on this as it is equity generated and remains in a LOC until you purchase next, then I CANT see how it can be classed as income?

Just my thoughts thou, but interested to hear if any accountants in the forum have a view on this...

[captaincrab]

Income is income and tax should be paid on income. I dont where your Mortgage Broker is coming from about converting equity to income, but if you make a declaration as to what your income is and it is different to what you say to the IRD and the IRD pick it up then you will undoubltedly have questions to answer. One of the reasons the IRD removed the requirements for PAYE earners to file returns is to free resources to chase down those who evade and avoid. I know for sure that the IRD sent a team down to Qtown/southland to look at people who were trading a lot of property by buying and then selling on before settlement to a third party. I have been told my local contacts that a number of Real Estate agents got big shocks as the IRD got right into their Trusts they thought they could hide behind.
One of the companies I'm associated with sells a huge amount of property to Australians and in talking to the resellers they have had several clients who have been got at from information lodged at the lender. If the IRD walks into your office and demands information held in your files. You have to give it to them. They can have you arrested if you obstruct them. Lo-docs can be a double edged sword if you lie. Morally I have no sympathy for those who take all the benefits our society provides and then evade Tax because they are in the "black economy" and then cant get a loan because they cant prove their "real" income. Valid avoidence is another issue.

[SuperDad]

Captaincrab,

I'm not trading property. The "income" that has been generated by my property has been generated by increasing the value and borrowing against that increased value. My broker assures me that this is a common practice in the brokerring industry.

I am completely aware of the tax implications of trading, and of the IRD's investigations into the trading in Queenstown. Again, I'm not trading.

The fact that I call an amount "income", and that a lender is happy to consider that amount as "income", does not entail that the IRD will view that amount as income. (My son might call his pocket money income, and tell his friends that he earns $5 income per week. It does not follow that the $5 is income or that, if it is income, that it is taxable.) Nor does it guarantee that they won't. This is why I said above that I will need to check this with my accountant.

[captaincrab]

Hi Paul, I was going off on a tangent about lo-docs declarations and wasnt referring to your situation. However I disagree with your Broker saying "this is a common practice in the industry". Its a Capital gain , not income.And if you start calling capital gains income you open the door for the Govt to tax it. I deal with Brokers all over NZ (Auckland,Hamilton, Wellington, Christchurch and Queenstown/Wanaka and quite a few in OZ). None hold the same view as your Broker.
Your son's pocket money is income and if he was paid more than 19500 pa he would pay tax. Since hes under the taxable threshold he doesnt. My son is a beneficiary of a Trust and his income is taxed. Do you think if I called it "pocket money" he could avoid it? I think not.The IRd probably have a definition of income somewhere.
Cheers
CC

[whitt]

My knowledge was that lenders use 2 ways to determine your borrowing ability.

LVR. Loan to value ratio ( equity)
DSR. Debt service ratio. ( income)

In this case if Superdad's broker is correct counting it as income would improve the DSR and but have a negative impact on the LVR.