There’s been a lot of hype and misunderstanding around the term ‘negative gearing’ over the past couple of decades, particularly when it comes to negatively geared property investments.
Some investors will tell you that negative gearing is a very effective investment strategy that will reduce your income tax and provide you with a big fat tax return every year – happy days! Some will tell you that negative gearing is the only way for low-to-middle-income-families to invest in property because a negative gearing strategy allows you to build a portfolio without using your own money – sounds awesome!
But other investors will tell you that if your investment strategy is designed to lose money from day one then you must have rocks in your head to even consider it – okay, now I’m confused!
So what is negative gearing, exactly? And how does it work?
‘Negatively geared’ investments are those investments (such as shares or property) that are costing you more money than they are making you. This loss can be used to reduce the income tax applied to other income sources such as your salary or wages. The investment returns a loss in the short term, with the view that it will rise in value over time and produce a large financial gain in the long-term.
|IMPORTANT: Saving tax should never be the primary objective of any investment. If your investment is making you a healthy return over the long-term, AND saving you some tax in the meantime, those tax savings can be viewed as a happy little bonus. But if you are using negative gearing for the sole purpose of saving tax you are, by definition, losing money! Your MAIN GOAL with any investment should always be to make maximum after-tax profits.|
So how does negative gearing apply to property investment?
When you rent or lease your property to someone to produce income, you have to pay tax on that income. But you also need to pay for rates, management, maintenance, insurance and various other expenses to sustain your property (including the interest on your loan). All of those costs are tax deductible.
If the total cost of rates, management, maintenance, insurance and interest on the loan is greater than the income you receive from the property, then you have a negatively geared investment property. And you can claim this loss as a deduction against your taxable income (salary or wages for example).
Negative Gearing in Action
An example: Shelly has purchased an investment property in Brisbane for $350,000. The annual cost of holding the property is $32,805 which comprises of:
- Interest repayments on the loan: $16,851
- Rental Expenses: $7,088
- Property management fees: $1,638
- Letting Fees: $350
- Rates: $1,500
- Insurance: $600
- Maintenance: $3,000
- Non-Cash Deductions (Depreciation): $8,136
- Loan Costs: $730
Total costs per year = $32,805
But Shelly also collects $18,200 per year rent from her tenant, therefore her net cost per year is reduced to $14,605 ($32,805 – $18,200 = $14,605).
Shelly’s Brisbane investment property is negatively geared by $14,605 per year, so this $14,605 can now be taken off her annual taxable income:
So if Shelly’s taxable income was $50,000, her taxable income would now be reduced to $35,395 ($50,000 – $14,605 = $35,395) thanks to her negatively geared investment property. This reduces the amount of tax she has to pay, or in other words provides her with a tax credit.
A closer look at the taxes
- New Taxable Income: $35,395
- Present Tax (i.e. tax on $50,000 at the marginal rate of 34.5%): $8,547
- New Tax (i.e. tax on $35,395 at the marginal rate of 34.5%): $3,530
Tax Saving or Tax Credit: $5,017 ($8,547 – $3,530)
Now Shelly can either wait until the end of the financial year to claim a tax refund (having already paid tax on the entire $50,000 throughout the year) or she can use a PAYG Tax Variation and ask the ATO to take out less tax each time she gets paid. This way, Shelly’s tax return is effectively spread out over the financial year instead of being delivered in one lump sum at the end. For many investors this step is crucial, because it gives them the cash-flow they need throughout the year to cover the costs of holding the investment property.
A $14 per week investment property
Shelly’s negatively geared investment property actually only costs her $722 per year or $14 per week to own. Let’s see how that works out:
We established that the loss on the property was $14,605 per year. But that included depreciation of $8,136 and loan costs of $730 (these are losses/costs that count for tax purposes but don’t come from Shelly’s pocket). The cash expense therefore, is $14,605 – $8,136 – $730 = $5739, so after our tax credit of $5,017 the cost of owning the property is only $722 per year or $14 per week.
- Tax Credit: $5,017
- Annual Cost or Shortfall: $5,739 (costs) -$5,017 (tax refund) = $722
- Weekly Cost: $722 / 52 weeks = $14 per week
This is a very effective investment strategy for Shelly because it enables her to own an investment property for only $14 per week. If Shelly did not have access to the tax benefits/credits that come with a negative gearing strategy, she simply couldn’t afford to hold the investment property. This strategy is helping her to invest for her future, potentially replace her income or retire early, or at the very least become a self-funded retiree who is not dependant on the pension in her old age.
If I can own an investment property for $14 per week, why can’t I just buy 10 properties and get rich quick!?
Despite the hype from real estate agents and property marketers, negative gearing is not a “magic potion” or “fast-track to riches”.
Firstly, although negative gearing can make an investment affordable, it’s capital growth that builds your wealth. In the example above, negative gearing made Shelly’s investment very affordable, but to grow her wealth, the property has to increase in value over the long term (this rise in value is called capital growth).
Secondly, the bank isn’t likely to lend you $3.5M to buy 10 houses on day 1. But buying that first property does indeed unlock bigger opportunities. A couple of years of good growth for Shelly would increase the value of her home enough to make the banks happy to lend to her again for properties 2 and 3. For further explanation (and examples) of how capital growth works for you, read our previous article – Capital Growth: The most important consideration when buying an investment property.
Thirdly, negative gearing is just one strategy. Main Street Group focuses on ‘8 Key Strategies’ for creating wealth through property investment. Negative gearing is simply one of them, and it suits some investors better than others.
Who determines capital growth?
The market decides whether the value of your property grows quickly. Profitable investing therefore depends on selecting the right properties in suburbs that are primed for fast capital growth. Because capital growth is the most important factor, we do extensive research for our clients to make sure they are investing in the highest-growth areas in Australia.
Call us for advice on your own situation today on (07) 3510 2122, read about our Property Concierge Service, or if you’re still working on your finances check out our 1-on-1 Financial Independence Workshops and our long list of great results.
Andrew Clough | Founder of Main Street Group
Ph: (07) 3510 2122 or contact me via email here
DISCLAIMER: The information in this article is general information only and should not be mistaken for financial advice. The information shared in this article has been prepared without taking into account your personal objectives, financial situation or needs. Before considering any investment strategy, you may wish to consult a licensed financial adviser – in fact we recommend that you do.