When running your feasibility on a development project, it's important to make sure all costs are covered off. There are set up costs, design costs, planning costs, construction costs, selling or leasing costs and of course, the dreaded holding costs.
You must calculate holding costs correctly. I've spoken to many novice property developers about their holding cost calculations. The most common mistake is to simply calculate the interest cost over the total cost of the project for the total time a project will take.
This results in a gross over calculation of interest costs. In addition, they then don't take into consideration the tax benefits on the interest payments.
Admittedly, It's not an easy calculation because of the various timeframes and draw downs applicable over the life of the project. So I thought I'd put a case study together to demonstrate the holding costs on a dual occupancy project.
The basic rule is that when an expense is incurred in earning income, it will be allowed as a deduction as long it is not capital in nature or private.
A property investor is buying as an 'individual' (i.e. not in a trust or company structure). The investor's taxable income is $95,000 per annum and she has purchased land that will be developed and once completed, be income producing.
Exchange on land took place on the 1st February 2015 using $5,000 deposit.
Settlement on the land occurs 1 May 2015.
The development will be completed 1 of December 2015 when tenants will move in.
Interest rate is 4.5%, and we assume the project will be 100% financed.
The land cost is $265,000 and stamp duty is $7,765 but after a NSW government grant it is reduced by $5,000 and is $2,765. Legal fees are $1,800.
The builder's contract is $460,000 and includes all costs relating to design, planning, subdivision and construction.
The drawdowns occur as follows:
- 1 April 2015 – $5,000 deposit paid
- 1 Aug 2015 – slab down
- 15 Aug 2015 – Frames and trusses completed
- 15 Sept 2015 – Brickwork completed
- 1 Nov 2015 – Interior linings completed
- 1 Dec 2015 – Completion
Below is the builder's drawdown schedule:
|Deposit paid after concept plans agreed on||$5,000|
|Installation of concrete slab (less deposit paid)|
|Erection of Timber Frame and Trusses|
|Brickwork, Windows and Roof Coverings to Main Section|
|Interior Linings and Mouldings|
What could be the tax benefits on the interest holding costs?
Interest expenses incurred while constructing properties which will produce rental income will be allowed as a tax deduction in the year it is incurred.
In the case study provided, even though the construction won't be completed until the following tax year, the interest incurred in financing the land and any progress payment will be deductible. Also deductible will be any council and water rates.
Using the case study details, we have calculated the
- Amount of interest which can be deducted and
- Tax savings which can be obtained at the end of 2015 – assisting with cash flows.
So what were the results?
Deductible interest expense for 2015 financial year is estimated at $2,015 with tax benefit of $786.
For the 2016 financial year, the deductible interest amount is estimated at $28,197 with tax savings estimated at $10,997
The total interest holding costs for the project is $18,429 for the eleven month period that the project will take to complete.
This particular dual occupancy project was projected to create approximately $153,000 in equity. Even after the holding costs are deducted it's not a bad return for just under a year's work. What do you think?