For many Australians, it is a reality that at some point the family home will be sold (voluntarily or not) to prepare for, fund or fuel retirement. It is a complex decision with many moving parts. Like most complex, multi-dimensional financial decisions, a financial adviser is best placed to help you navigate through all the financial considerations and tradeoffs.
Following is an outline of some of the most important thoughts and insights into the subject:
1. Financial benefits of the family home
The majority of wealth in Australia is in property and the majority of that is in the family home…and for good reason. A combination of unique property market dynamics that have driven prices North for decades plus a range of tax benefits have made the family home the store of most people’s wealth. So let’s have a quick look at what the main tax benefits are:
• Capital Gains Tax Free: This is the big one, it’s hard to understate how important a factor this is, especially when the asset actually grows in value. It’s not worth much being CGT free, if there is not much gain to begin with. Australians who live in the major capital cities have benefited the most from this.
• No Land Tax: Unlike investment property that at some point can attract Land Tax, the home doesn’t incur that cashflow burden.
• Assets Test Exempt for Age Pension calculations: I do think of this as a “tax benefit” because if it was wholly or partially assessed then you would be “taxed” via a reduction in your Age Pension. More on this one later.
2. Understanding your balance sheet
It’s important to see you balance sheet correctly. If you don’t see if honestly, you hinder your ability to make good decisions.
What is your net worth? All assets less all debt. That is the starting point of any discussion about downsizing.
What is the value of your home?
Once you subtract the value of the home from your net worth, you are left with a number. That number is what is available to fund your retirement. If you are approaching retirement and you still have a mortgage and debts, it is not uncommon for the value of the home to be more than your net worth.
For example:
| Home | $900,000 |
| Mortgage | $500,000 |
| Other Assets | $100,000 |
| Super | $350,000 |
| Total Assets | 1,350,000 |
| Total Debt | $500,000 |
| Net Worth | $850,000 |
| Subtract Home Value | -$900,000 |
| Funds Available for Retirement | -$50,000 |
If these were the numbers as you are preparing to retire, and there was not likely to be an inheritance to tidy up the debt, downsizing is almost a certainty.
3. Age Pension considerations
There is a favourable bias towards the home embedded in Age Pension calculations. It can often lead to government support distortions as you can have a $3m home and not much else and qualify for the full Age Pension.
This bias actually inhibits retirees from restructuring their wealth to take capital out of the home and generate an income with it. Why would they when that would lead to a reduction in pension?
The full Age Pension is about $34,000 for a couple, it is a lifetime payment and indexed. To purchase the same income stream in the form of a private annuity, you would need close to $1m. The capital value of any reduction is significant so it is very rational to want to “hide” one’s capital in the family home.
4. What does the word “Downsize” mean?
Many clients have spoken about downsizing over the years and in many of those cases what they were referring to was a reduction in space and size, but not a reduction in capital value. In some cases they were “downsizing” to a more expensive apartment closer to the city!
Financial advisers think of the word in terms of a reduction in price. Moving to a cheaper home, and in doing so freeing up capital for a wide range of purposes such as:
• Debt reduction (most common reason)
• Top up super
• Helping the kids
• Funding some travel in early years of retirement
5. Timing…when to do it?
If you decide to downsize, you are left with the big decision of When?
Do you do it sooner rather than later, to free up capital to spend during the healthier more active years of your retirement and to do all the travelling that you always wanted to do. But risk less financial security in later years?
Do you delay it as long as possible and hopefully pick up more gains on your home (assuming you are in a growth market) to try to increase financial security in later years?
As with all good questions, the answer is, It depends. It depends what you want to value. It depends on how financially disciplined you are. If you have poor financial discipline and spend too much in the early years you are likely to pay for that with increased financial stress in later years.
There is no perfect answer, just an awareness of the questions that need to be considered and the balance that needs to be found.
6. Sequence
As a general rule it is best to sell first and then buy, even if that means renting for a while. Obviously if you can afford to comfortably own two properties and service the loan required to do so, then that might be an option for you. But most people would be putting themselves under a lot of financial stress in that situation.
That financial stress often translates into a poorly negotiated sale of the old home as it was conducted under pressure. You are putting yourself in a position where you are likely to accept a less than ideal price for your old home.
If the sequence is right, and you are renting while looking for the new home, you can take your time and wait for a good property that you negotiate for without pressure and increase your chances of buying it at a good price.
7. What to do with the cash?
You have sold your home, you are now renting and looking for your new home. A common question is what to do with the cash?
The answer is that it needs to be totally “Risk Off”, so a high interest bank account (I know that sounds like an oxymoron) or a short dated Term Deposit e.g. 90 days. Buying shares or even diversified managed funds will embed volatility into the money and that can cut both ways quickly if market conditions change.
8. Forced or Choice?
Do you have to downsize? I think that is the most important question to come to terms with. If you don’t need to, then it is a lifestyle choice. But if you need to, it’s a financial choice.
The answer to this question lies in your balance sheet (Point 2) and in the amount of income you want/need to maintain the lifestyle you want/need.
If you need to downsize, the sooner you realise it the better. It needs to be planned for as best as possible and the more time you have to do it, the more likely you are to make.
9. Managing debt during you working life
How you manage you debts during your working life directly impacts the types of decisions you will be faced with during retirement.
If you are disciplined in reducing your debts, especially you non tax deductible home mortgage you are less likely to be forced to downsize.
If you have borrowed too much or don’t pay off the principal of your debt enough, a downsize might be the preferred way to “reset” your situation and become debt free and create enough capital for income generation.
This is one of the many benefits of working with a financial adviser, someone who can help you work out the three dimensional nature of these considerations.
10. Inheritance and Downsizing
There is a clear correlation between likely/certain inheritance and the need to downsize. It is certainly part of the thinking and decision process. It is sometimes an issue that clients feel uncomfortable discussing or admitting reliance on.
You need to weigh up your decision making timeline with the timeline of your likely inheritance.
11. Frictional Cost
The costs of selling and buying are often underestimated, but the shape of the number is about 8%.
Selling a property will cost you about 3% and buying into a new one will cost you about 5%. So the simple maths is about 8% (although the price of each property will be different).
This needs to be part of the thinking as sometimes spending that money on home modifications and a makeover is a better way to spend the money rather than the selling to buy into a “better” home.
12. Living off home equity
Downsizing is really a process of “equity release”. In that context it needs to be discussed along with other equity release options currently available such as the terribly named Reverse Mortgages and Shared Equity strategies.
Other equity release options could be a better way to release capital and increase income while “buying time” to stay in your current home and maybe come back to the downsize question many years down the line.
You could think of it as a Staggered Downsize with different tools and strategies used at different stages of your life.
