Property investors have enjoyed strong capital gains during the past 18 months that have more than offset softer rental returns in areas of oversupply. But the prospect of falling, or even flat, property prices is a signal for investors to check that their property strategy is still sound.

People nearing retirement, especially those with negatively geared investment property, need to be especially cautious. Michael Dirkus, of the Australian Taxation Institute, says such investors need to think carefully about their investment strategy if the property market falls.

An investment property is negatively geared if the costs of ownership, including interest payments on the loan and building maintenance, exceed the rental income. Many investors are fixated on the tax deduction for investment losses, whereas the strategy only makes financial sense if you convert those losses into a capital gain as property values rise.

Property investors nearing retirement are faced with several choices. Wealthy individuals may continue to build their property holdings with borrowings. However, most people, aim to reduce their debt on their property so it is positively geared, that is, producing net income, or owned outright by the time they retire.

Others choose to downsize by releasing equity in their own home or an investment property, and use the money to produce income.

Ross Johnston, head of financial planning strategy at IWL (InvestorWeb), says gearing is most appropriate for an investor on a high marginal tax rate with a high disposable income who already has sufficient funding in super and is risk averse. Most retirees will fail on at least the first two counts.

Retirees are also unlikely to have insurance against loss of income, which makes gearing even more of a risk. "Gearing is a good way to build up a nest egg in the pre-retirement phase, but if you are very close to retirement I would not think gearing is appropriate," says Johnston.

"The first thing retirees should do is reduce debt." Johnston believes most retirees are better off selling property and rolling the proceeds into an income stream such as an allocated pension to diversify their underlying investment portfolio and to gain the most under Centrelink's income and assets tests.

ING's technical services manager, Andrew Lowe, says people need to take into account whether they can contribute the proceeds of property sales to super.

This is because recent retirees have a window of opportunity during which they can contribute money into superannuation and roll it over into an allocated pension and enjoy considerable tax advantages (see case study).

If you draw a pension from super some of the income may be tax free, and income above the tax-free threshold may still attract a 15 per cent tax deduction to offset capital gains tax payable on the sale of investment property.

You can contribute to super if you are under 65 and have been gainfully employed for at least 10 hours a week within the previous two years. You can continue to make contributions up to age 75 but only for weeks where you were employed for at least 10 hours.

Margaret Lomas, author of the forthcoming book How to Maximise your Property Portfolio (Wiley, $24.95), says the size of your property portfolio is an important consideration. "Someone with one property who doesn't want the hassle of being a landlord may be better off liquidating the asset, living on the income and drawing down the principal as they need it," she says.

"If I have $10 million in property I won't get the pension in any case."

Even if people can't, or choose not to, invest the proceeds of property sales in super, Lomas says they will normally be better off delaying the sale of investment property until after retirement when they have little or no other income and will pay capital gains at a lower marginal tax rate.

Someone with a number of properties may be better off staggering the sales over several years to reduce the overall capital gains tax burden.

Although property is generally regarded as a less liquid investment than alternative assets such as shares, that is no excuse to "set and forget" your property portfolio.

Lomas says investors don't necessarily need an exit strategy when they begin investing, but she advises people to monitor and fine-tune their property portfolio as their circumstances change.

Investors also need to take their investment time frame into account when they take out a loan because fixed rates are generally less flexible if you decide to repay your loan early.

Margaret Callinan, research manager at Tandem, explains that if you lock into a five-year fixed rate but interest rates fall and you decide to pay out the loan after two years, you will have to pay the difference between the old and new interest rate for the three years your loan had to run. However, if rates rise, it is in the bank's favour to let you out of the fixed loan and you won't have to pay any extra.

There is not a great difference between the average variable rate of 6.25 per cent and the average five-year fixed rate of 6.71 per cent, so it is not costing a lot for investors to fix part of their loan.

"If rates go down you're not benefiting, but if they go up you're laughing," says Callinan.

When retirement approaches, Lomas says everyone needs to do their own calculations, especially where Centrelink guidelines are concerned.

For example, all income from rent is assessed under the income test, whereas Centrelink deems that shares and managed funds return an income of no more than 4 per cent.

However, if investors wish to continue building wealth after retirement Lomas points out that rental income from property is the only unearned income most banks will accept as income for borrowing purposes.

When interest rates begin to rise, Dirkus says, cashedup investors could find buying opportunities (see cover story) when people who need their cash for other things bail out of rental property.

Window of opportunity

As a recent retiree, she could claim a tax deduction for super contributions, but she elects to make an undeducted (after tax ) contribution with her property proceeds and receive the tax benefits when she withdraws the money in the form of an allocated pension.

The undeducted purchase price of a pension is divided by either the term of the income stream or life expectancy to give an annual tax-free amount.

Because Marion has less than her reasonable benefit limit invested in super, income above the tax-free amount is taxable at her marginal tax rate less a 15 per cent tax offset.

The maximum and minimum annual payments Marion can withdraw are calculated by dividing the account balance of $300,000 by a pension valuation factor (PVF) based on her age:

Tax free amount is $14,493 ($300,000/20.7 – life expectancy for a 64-year-old female).

Marion can draw $14,493 free of tax each year.

She is required to draw at least $18,520 in her first year so at least $4027 will be taxable at her marginal rate, less a 15 per cent tax offset.

Source: ING Australia.

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