There are not too many negatives about negative gearing, but that doesn’t mean it will work for everybody in all cases.
Negative gearing occurs when the income from an investment is less than the costs associated with that investment.
The classic example is when an investor buys a property. It’s rare for a property to be bought outright. Most likely they will need to borrow to finance the investment, a practice referred to as gearing. While gearing means any gains will be amplified, so will any losses.
And it is worth noting that property can lose value just like shares. Buying at the top of the market may mean that an investor can have a long wait to see any capital growth.
Negative gearing should not be the aim of an investment but rather a means to an end. You need to make a good investment in the first place. If the property doesn’t increase in value over time, then it’s likely you’ll be out of pocket overall.
Say an investor bought a property worth $400,000 with a $40,000 deposit. With a mortgage rate of 5 per cent, their annual interest bill on the $360,000 loan over 25 years would be $25,380 ($2115 a month).
If the property rents for $1800 a month, then they would have to find $315 each and every month to meet that shortfall. And that assumes the property is fully occupied week in, week out.
While that’s clearly a negative, there is a positive side to this shortfall. In Australia an investor can offset the costs of the investment against their personal income tax. Not only can they claim the interest on the mortgage but they can also claim other allowable expenses associated with the property such as the rates, repairs and any depreciation.
If the property is new an investor can depreciate it over 40 years – that’s 2.5 per cent a year. This depreciation applies to all properties built after 1985.
For those on the top tax rate, these concessions can lead to a significant reduction on their tax bill. However, for someone who pays no tax or low tax, then these deductions have little or no value.
Assuming an income of $100,000, the tax savings would be as follows:
Your Personal Tax Position
|Annual Rental Income||$17,888.00|
|Present Annual Tax Payable||$24,947.00|
|Present Average Tax Rate||24.95 %|
|Total Tax Deductions||$36,408.28|
|New Annual Tax Payable||$18,094.50|
|New Average Tax Rate||18.09 %|
Negative gearing should not be the aim of an investment but rather a means to an end. It’s important to make a good investment in the first place. If the property doesn’t increase in value over time, then it’s likely an investor would be out of pocket overall.
Much of the current housing boom has been driven by investors – in particular self-managed super funds. These investors are attracted not only by the ability to negatively gear but also by the 50 per cent capital gains tax reduction on investments held for more than 12 months.
Indeed, in August investor loans still accounted for more than 40 per cent of the value of approvals.i Since then lending institutions have moved to increase interest rates for investor loans to act as a deterrent.
Until the capital gain is realised, a negatively geared property is likely to see money flowing out. So not only does an investor need to make sure they can cover any shortfall, they also need to have sufficient funds in reserve for any unforeseen circumstances such as the property being untenanted or the need for major repairs.
Negative gearing also tends to work best with city properties because they are likely to increase in value at a faster rate than regional properties.
Regional properties are more likely to be positively geared. That’s because house prices tend to be lower on average outside the big cities but the disparity in rents is not so great. Rental yields can be up near the 10 per cent mark in regional areas, which means the rental income will likely deliver a positive cash flow.
Positive gearing may also be more appropriate for retirees who pay little or no income tax or those on a low tax rate. After all, if they aren’t paying any tax in the first place, what is the benefit of a tax deduction? And in retirement they will most likely depend on the rental income they receive from their property.
If a property is positively geared, not only does the investor receive an income but they can use the cash flow to pay off the mortgage faster.
In recent years, concerns have been raised about the generosity of negative gearing and the 50 per cent reduction in capital gains tax with the result that both items are on the Australian tax reform table.
But in the absence of any of these potential changes, negative gearing does have some benefits.
Negative gearing isn’t just for property. An investor can also negatively gear share investments although this can be a high risk strategy and there are fewer tax deductions.
If share prices fall below a certain level, then the lender will require the investor to make a margin call. This means they will have to find further funds to restore their borrowing to its original percentage.
As a result, gearing into property is seen as a less risky option.
If you would like to discuss negative gearing in the context of your overall investment strategy, please give us a call. It could be a positive move.
i ABS Housing Finance, August 2015, http://www.abc.net.au/news/2015-10-09/owner-occupiers-take-lead-in-housing-finance/6841228