Negative gearing - an explanation
You’ve heard of negative gearing: it’s a phrase that pops up occasionally. But what does it mean, and, more importantly, will applying it to your situation help you get ahead?
What is negative gearing?
Negative gearing is a phenomenon which only exists a in a few countries and Australia is one of them. It refers to the borrowing of funds to pay for a home which the buyer then rents out. As rental income is usually less than the cost of the interest paid on the property (and expenses associated with keeping it) the investment is considered to be “negatively geared”. The reason there is positive vibe around negative gearing is that a negatively geared property can offer immediate tax benefits while also offering the prospect of capital appreciation over time. For those two reasons, negative gearing tends to be adopted as a financial strategy by property speculators or people with a heavy tax burden.
Negative gearing and tax benefits
The ATO allows investors to offset an income loss incurred on a real estate investment against another form of income. An income loss is where the property costs are higher than the rental income from the property. Chances are you will still be out of pocket but the upside is you are gambling on a potential capital gain that will ultimately be worth more than a definite loss of income.
How does it work? Interest on the investment loan is fully deductible. So, even if the rent you make on the property in the first year leaves you a couple of thousand dollars short, you can “save” money off your tax bill by deducting the interest spent from your total earnings (salary, wage or rental income). This reduces your overall tax debt as it reduces your taxable income.
Other deductions are also allowed but things can start to get more complex when the property is sold. One deduction is for depreciation. Another is for capital works. (Capital works receive a deduction of 2.5 percent per annum on the initial cost). At the time of selling, capital gains tax must also be paid on the proceeds minus cost base, not including items such as property fixtures and fittings. (These fittings can receive a deduction for depreciation though). After all the various deductions are taken into account, the net capital gain is taxed as income, but if the property has been held for a year, this is then discounted by 50 percent for an individual, or 33.3 percent for a super fund. Obviously expert advice is required to stay on top of the allowable deductions.
The key thing to realise, of course, is that if the property is costing you more to hold than it is generating for you, you will have to cover the gap from your own pocket until the income from the property rises or the expenses on it reduce. Perhaps for this reason, negative gearing is often used by higher income earners to reduce their actual taxable income in the short term and make theoretical money over the longer term (capital gain).
A risky business?
Large assumptions must be made in this area. Interest rates, maintenance, capital appreciation, as well as future tax rates all need to be carefully thought through. There is often negative media coverage about negative gearing, sometimes with good reason. Why? Plenty of people see property as a sure fire money-earner but this is not always the case. Some people would say the only thing guaranteed is the loss of money, if only initially. Furthermore, it’s not that you don’t avoid paying tax but rather simply defer the debt until you sell the property, when depreciation savings become subject to capital gains tax.
How to manage the risks of negative gearing
There is always a big risk associated with undertaking a negative gearing strategy, and borrowing to fund this type of investment. Although the main objective of negative gearing is to increase your return on borrowed funds, if anything goes wrong, the losses can snowball quickly, into quite substantial amounts. This is why it is recommended that only people with the financial allowance to cover the effect of these potential losses should negatively gear properties. In order to protect yourself from the risks of gearing, there are three main things you can do.
Firstly ensure you choose your investment property carefully. In order to avoid losses you have to purchase a property that will increase in value. This is where research comes into play, look at recent growth areas, recent areas of property price increases and the rental returns in certain areas.
Secondly you have to have a backup plan incase there are problems with rent coming in. You will have to have sufficient spare income available to cover the loan repayments if you have a tenant who does not pay rent on time in some months, or even if your property remains vacant in between tenancies.
Thirdly you can take out mortgage insurance, this would cover your payments in certain events where you could not make the payments yourself.
In short, if something has tax advantages it is for a very good reason. Negative gearing will build wealth for you if there is a rapid price increase in the property market but you will have to work hard to get the benefit. Having a steady cashflow that can comfortably meet the gap is also important or you could find you are over-exposed. So, if you have your heart set on early retirement, then negative gearing is not the easy option – before you embrace it make sure it is a strategy that suits your goals and situation.