Hearing all this chatter about negative gearing in Australia and want to know what the fuss is all about? Or perhaps you’re considering purchasing a property and trying to decide as to whether negative or positive gearing is suitable for you?
This guide will explain to you exactly what it is, who it benefits, share some tips and busts some myths associated with negative gearing so that you can be fully informed when making your property investment purchase.
What is Negative Gearing?
At its most fundamental definition, gearing is when you borrow to invest. Therefore, for the purpose of this article, we are referring to gearing only specific to property investments.
Negative gearing can be a complex topic but the simplest way to explain negative gearing for property investment is this:
An investment property is negatively geared when your net rental income minus your expenses associated with maintaining the property is less than the interest on the funds borrowed to purchase the property.
Conversely, positive gearing is the opposite: when your net rental income is greater than the interest on the funds borrowed.
Negative Gearing Benefits – Why Negatively Gear?
The majority of investors choose to negatively gear as a tax minimisation strategy. But what does this involve?
By producing a net loss on the income of your property, you can reduce your tax bill significantly. As your investment income and income generated from your job or business is calculated together, you can reduce your total assessable income if you are running a loss and thus, saving yourself in tax.
How does this work in the long run? Growth in the property. Investors hope that by negatively gearing their property and by recouping some of the tax losses along the way as well as taking advantage of the 50% CGT discount when they sell the property, they hope to make a profit in the long run.
The tax savings can be particularly pronounced to middle-to-high income earners who are taxed at a higher rate in Australia.
You might also be interested in our Ultimate Investment Property Tax Guide
Negative Gearing Example
Below is a simple example based on 2018-19 tax rates:
George and Katherine both earn around $100,000 per year. They are both thinking about buying an investment property worth $500,000. The interest on their investment loan is 6% pa an interest-only basis.
They will have extra property expenses estimated at $6,000 a year. Rental income is expected to be $500 a week ($26,000 a year).
George is expected to borrow the $500,000 needed to buy his investment apartment as he has no savings. Interest on the loan is $30,000 a year, which is tax-deductible.
Katherine has some savings so she only needs to borrow $100,000 for a similar apartment. Katherine’s interest payment is $6,000 a year, which is also tax-deductible.
|Income prior to buying property||George: Negatively Geared||Katherine: Positively Geared|
|Add rental income||–||$26,000||$26,000|
|Less interest||–||– $30,000||– $6,000|
|Less property expenses||–||– $6,000||– $6,000|
|Net Taxable income||$70,000||$60,000||$84,000|
|Income Tax||– $15,167||– $11,047||– $18,847|
Note: this example is reflective of the first year and does not consider fluctuations in rental income, interest rates, land tax nor depreciation. Over time, taxable income could begin to exceed tax deductions and the property may no longer be negatively geared.
As you can see George is negatively geared and Katherine is positively geared. Given that George has less money in his pocket despite making more significant savings in tax, he will be counting on future potential capital gains to recoup these losses. This example does not apply for owner-occupied situations.
Dangers & Myths of Negative Gearing
In a housing boom, it’s easy to do the calculations and figure that negative gearing is a great option to capitalise on property investment without having to put too much capital down initially. There are, however, dangers associated with negative gearing as it relies on a number of factors. These risks can include:
- Cash flow shortage
- Ensuring maximum tenancy
- Property market downturn at the time you wish to sell your property
- Unable to meet loan repayments
- Changes in tax laws
Future-proofing some or all of these factors are important to minimise your investment risk. By speculating on the increased capital value of your property, this can prove to be a poor investment strategy if you run into trouble with one of the above risks.
There is a great deal of benefit engaging in a financial planner or an accountant who can run these numbers for you.
Negative Gearing Myth #1: Negative Gearing Promotes Increased Supply of Homes
Statistically speaking, over 90% of mortgages are approved for existing homes rather than new ones. Therefore, negative gearing has little to no effect on the new housing supply.
Negative Gearing Myth #2: Negative Gearing Decreases Rent
Simple economics will tell you that the only factor determining price is supply and demand. While people correlated property investment increase to increased supply, this is simply not true and studies have shown that it has no effect or potentially even the opposite effect.
Negative Gearing Myth #3: Negative Gearing Ensures Maximum Property ROI
The property investment market can be like the health industry – lots of contradictory advice and misinformation. In the hysteria of buying a property during n unprecedented housing boom, many investors are using negative gearing as a major factor in deciding on a choice of property. This can spell a lot of dangers. In an effort to negatively gear an investment property, investors can often ignore or place a lower emphasis on other factors that affect the quality of the property.
Negative Gearing Myth #4: Negative Gearing Helps Low-to-Middle Income Classes the Most
One of the biggest factors to consider when deciding to negative gear is your taxable income and the tax bracket in which you fall in. Given the progressive nature of our tax system, higher-income brackets often enjoy bigger tax breaks from negative gearing and thus, helps the upper end of income earners a lot further than your average families.
The general strategy for property investment, like any investment, is to grow your wealth. People correlate this with capital growth which can be attained both geared positively and negatively. The added element of minimising your tax burden with your property investment is what is attractive for negative gearing. When it comes to determining whether negative gearing is right for you, there is no generic answer for all. Given the wide-ranging number of variables that must be considered, it’s important to assess your individual financial and personal situation before deciding to make the leap into negatively gearing your property.
Engaging in a financial planner or an accountant can provide an expert second opinion to ensure you are on the right track. Given this is one of, if not the most significant investment of most people’s lives, it pays to conduct thorough due diligence to avoid being trapped in a debt whirlpool later down the track.
Box Advisory Services can guide you with your investment choices whether for your business or personal. Simply book in a free consultation with us or call us to discuss your investment matter further.
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Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to contractors and small businesses. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek your own advice for any legal or tax issues raised in your business affairs.