It is well known that living off superannuation, or the pension, in retirement is not the most comfortable way to spend your latter years. After decades of mortgage repayments and capital growth, it should be no surprise that you will have a substantial amount of wealth tied up in your family home. If you’re wanting to get ahead in retirement, downsizing can potentially unlock equity and redirect some of your wealth towards generating an ongoing retirement income. If you’re able to downsize strategically, you will see the result is much better than simply moving into a smaller house, it can become a way of restructuring wealth.
Why do people downsize?
The family home is often purchased at a time when life looks very different.
A couple might buy a four-bedroom house because they have children, need a large backyard, want multiple living areas and require space for a growing family.
Fast forward 20 years later, the children may have left home. Suddenly, there are extra bedrooms that aren't being used, the garden is becoming a burden, the backyard and pool aren’t being used, and maintaining a larger property is consuming both time and money.
There main reasons that people choose to downsize include:
The children have left home. Extra bedrooms in a house may no longer be needed.
Maintenance becomes harder. Gardens, pools, roofs and large blocks can become increasingly demanding as people get older.
Lifestyle changes. It’s easier to live closer to restaurants, beaches, shops, public transport, medical facilities, or family and not be car dependent.
Reducing living costs. A smaller property may have lower rates, insurance, maintenance and utility costs.
Releasing equity. The most financially significant reason to downsize can be to release capital that has accumulated in the family home.
The basic downsizing strategy
Imagine a couple owns a family home worth $2 million and has no mortgage.
They decide they no longer need such a large property and purchase a smaller home or villa for $1.2 million.
Ignoring transaction costs for the moment, they have potentially released $800,000 of equity. This provides a few options for our retirees, the money could be kept in cash, could be used to help their children buy their first home, or they could consider using it to purchase an investment property and really profit from their decision to downsizing.
Buying an investment property when downsizing can become an interesting property strategy that provides cashflow to fund retirement whilst also building up capital in your investment portfolio.
The objective of this strategy isn't necessarily to maximise property ownership but rather to convert the wealth created in the family home into an asset that can generate an income stream.
The investment strategy in this case is to provide an income stream while also exposure to future capital growth.
However, the numbers must work for the individual investor. There is no guarantee that an investment property will generate positive cash flow or increase in value, and there are many costs involved when owning an investment property.
The tax advantages of the family home
One of the reasons this strategy can be attractive is the potential tax treatment of the principal residence. Generally, an individual's main residence can be exempt from capital gains tax if the relevant conditions are met. The Australian Taxation Office explains that the main residence exemption can apply where the dwelling has been the owner's home and other eligibility requirements are satisfied.
That means a home purchased decades earlier for, say, $500,000 and now worth $2million may have accumulated a substantial capital gain without that gain being taxed whilst the property qualifies as a main residence.
This is one reason the family home can become an extremely valuable retirement asset.
However, investors should obtain professional tax advice before making decisions. Circumstances such as using part of the home used to produce income, renting out the home before selling, ownership structures and periods when it was not the main residence can affect the CGT outcome.
Downsizer contributions to super
There is another important consideration for eligible Australians, which is the downsizer contributions into superannuation.
Under the current rules, eligible individuals aged 55 or over may be able to contribute up to $300,000 from the sale proceeds of an eligible home into superannuation. A couple may potentially contribute up to $600,000 combined, subject to each person meeting the eligibility requirements.
The ATO confirms that the maximum individual contribution is generally the lesser of $300,000 or the relevant sale proceeds, and there are specific eligibility requirements, including ownership and main-residence tests and timing requirements. This creates another potential retirement strategy.
Depending on the value of your family home, it is feasible that your new strategy might become:
Sell large home → buy smaller home + super contribution + buy investment property + cash reserve.
The appropriate combination will depend entirely on the individual's financial position, age, income requirements, risk tolerance and retirement plans.
Investment property can create an income stream
The attraction of using surplus capital to buy an investment property is that the asset may potentially provide both rental income to fund a comfortable retirement as well as creating wealth through capital growth. The rental income can supplement superannuation and the Age Pension where applicable.
It is extremely important to consider all costs involved when owning an investment property. There may be Interest expenses, and there will be ongoing maintenance, insurance, management fees, rates, vacancy periods and other costs can materially reduce the net return.
Therefore, analysing the profitability of any investment property purchase should be assessed on its net cash flow, not simply its advertised rental yield.
The power of leverage and its risks
One potential advantage of downsizing is that the released equity could provide a deposit for an investment property without requiring the investor to use all of their available capital.
It could allow them to purchase a more valuable investment property than they could purchase outright. This kind of leverage can amplify returns when a property performs well.
But the risk is that it can also amplify losses.
If property values fall, the investor may still owe debt, and unlike someone in their 30s or 40s, a retiree may have a limited ability to increase employment income to cover rising repayments if there were any funds borrowed.
The risk of becoming asset rich, but cash poor
Downsizing is often discussed as a way of releasing wealth but it can create the opposite problem if poorly structured. It is important to recognise that any investment during retirement years requires liquidity. During your retirement years, you will likely have medical expenses, family commitments, travel, repairs, aged-care costs or simply the desire to enjoy life without worrying about every dollar.
If you are choosing a strategy of downsizing to invest, we recommend you speak to a qualified financial advisor and planner to determine your needed cash reserves, so that you are receiving investment returns to supplement but still have adequate cash reserves to fund your living preferences.
Any retiree should also consider whether they really want the responsibilities associated with property ownership because an investment property is not a completely passive investment.
Consider transaction costs
Downsizing comes with costs. Selling the family home will involve the selling agent's commission, marketing and legal expenses. As well as buying the smaller home involves stamp duty, legal costs and potentially moving expenses. Buying an investment property will also create another set of acquisition costs, which can materially reduce the amount of capital available for investment.
For that reason, downsizing should generally be considered as a long-term financial strategy rather than a short-term transaction and the financial benefit needs to be large enough to justify the costs of selling and buying.
Getting the right advice
Downsizing is a strategy that crosses several areas of financial planning. Before making a decision, it can be worthwhile speaking to:
An accountant or tax adviser — to understand CGT and tax implications.
Financial adviser — to model retirement income, superannuation and investment scenarios.
Mortgage broker or lender — if borrowing will be involved.
Solicitor or conveyancer — to manage property transactions.
Buyer’s Agent — to assess the proposed property and its potential.
The goal is to understand the complete picture before choosing to downsize and sell off the family home because the strategy only works if the numbers, tax implications and lifestyle requirements all make sense.
