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How Do You Benefit From Negative Gearing?

If you're a property investor or looking to become one, it's essential to understand what negative gearing is, and the possible benefits and risks that come with it.

For property investors in Australia, a clear grasp on the concept of gearing is essential when it comes to being able to make sound investment decisions.

Put merely, and gearing means borrowing a sum of money to purchase an asset – in this case, a property.

Gearing can take three forms: negative gearing indicates that the value of the interest you are paying on loan and other expenses is higher than the property generates in income (i.e. rent and the like), neutral gearing means that the income is equal to the overall expenses, and positive gearing happens when the income is higher than the sum of the interest you are paying and other expenses.

Negative gearing refers to buying an investment property that generates loss instead of income. That is, the total sum of expenses from maintenance, repairs, loan principal, and interest repayments exceed the rental income the property generates. Despite a potentially large recurring loss and being forced to pay some expenses out of pocket, some property investors prefer to invest in negatively geared properties.

Property investors in Australia use negative gearing tax concessions to minimise losses while waiting for long-term capital gain. The strategy allows investors to deduct the net loss on a rental property from their taxable income. How does this all add up, and is negative gearing an effective tax strategy?

 

Almost as prevalent as the Australian obsession with property prices is our on-again, off-again love for negative gearing property. Unless you are a property investor already, many of us still struggle with understanding what negative gearing is, and why making a loss on your property could be a good thing?

 

What is Negative Gearing?

To understand negative gearing, it is best to get back to basics. Gearing means to borrow money to make an investment and investors tend to positively, negatively or neutrally gear properties. Positively geared properties are when the rent you earn exceeds the amount of interest and outgoings payable. In other words, you make a profit.

Neutrally geared is where the rent equals your interest payments and outgoings.

Negative gearing is where your rental income doesn't cover the cost of repayments and outgoings, and you need to supplement from your salary or other income to meet your financial obligations for loan repayments and upkeep of your property. This is considered making a loss.

There are many technical intricacies of investing in property, with negative gearing being a highly discussed topic in the industry. As investors choose to hold onto their negatively geared property due to their own long-term investment strategies, it's important to understand the benefits.

Negative Gearing Benefits

There are many advantages of negative gearing. Targeting high growth areas is just 1 of 5 I want to share with you.

 

Negative gearing is a common investment strategy in Australia, and there are some major advantages to investing in property using the negatively geared strategy. I'm going to cover five advantages of negative gearing in today's episode.

 

Positively geared properties are actually much harder to find in Australia than they are in other countries. 

 

In short, you don't pay tax on a loss, and when it comes to negative gearing, you may even be able to offset that loss against your income, thus reducing your taxable income. For those on a reasonably high tax rate, negative gearing can be a positive thing. You can even claim depreciation on the value of improvements made to the property whilst it is being rented, such as a new kitchen, or renovations.

 

The key benefit of negative gearing is that any net rental loss you incur during the financial year may be offset against other income you earn, such as your salary. This reduces your taxable income and how much tax you have to pay.

Target High Growth Areas

Advantage number one of negative gearing, which is probably the reason why most people choose to go down this path, is that you can target high growth areas.

Australia is very much a growth market, meaning that even if you invest in positive cash flow property, the chances are that you want to achieve some capital growth in order to get the great return on investments that you desire.

Because negatively geared properties are basically everywhere, you basically have free rein over all of Australia, and you can choose top target areas that have high growth potential so that you can get that capital growth.

High Demand From Low Rental Fees

Some investors lower their rental rates to ensure negative income and keep their property negatively geared. In doing so, they can also benefit from maintaining long-term tenancy and, should the tenant leave, having more potential tenants to choose from.

Property depreciation is the natural wear and tear of the building and its assets over time. Investors of income-producing properties can claim this depreciation as a tax deduction. Depreciation is a non-cash deduction, meaning that an investor doesn't need to spend money in order to claim it.

All investment properties hold depreciation deductions that can unlock hidden cash flow. The gearing of a property doesn't impact whether an investor can claim depreciation. In some instances, depreciation can change a previously positively geared property to be negatively geared without experiencing a further loss.

 

Reduction In Taxable Income

The loss made from a negatively geared property reduces an investor's taxable income for each financial year. This tax offset can provide benefits for many types of investors, especially those with high marginal tax rates, or investors that are wanting to capitalise on their investment while they build their portfolio.

Let's look at a practical example to understand how this works.

Joe works as an engineer for a construction company. He purchased his first investment property in 2019. The property is leased to tenants who paid $25,000 in rent for the 2019-20 financial year.

While the property produces rental income, it also has many associated expenses. For the 2019-20 financial year, there was a total of $35,000 in expenses, including depreciation, interest repayments, insurances, property management fees and maintenance costs.

This resulted in a total loss of $10,000 for the 2019-20 financial year. Joe can use this loss to reduce his taxable income.

With his tax rate of 32.5 per cent, this loss brings his tax bill down by $3,250. This effectively reduces his investment property's loss to  $6,750. Given his goal of long-term capital growth, Joe is comfortable making a $6,750 loss.

hands exchanging house and money

Another benefit of negative gearing is the tax benefits that come with it. Now I'm not a tax accountant, so I can't give you taxation advice, always see your accountant before doing anything tax-related. Still, with investment property and with the negatively geared property, you are able to claim the loss of that property, plus any losses occurred through depreciation against your income. You may be eligible for a tax refund.

There are some tax benefits to investing with negatively geared property, which means you don't lose as much money every single month as you're paying out. Or in some circumstances, due to the tax refund, you may get more back than you payout.

This could make a negatively geared property a positively geared one. Again, always speak to your tax accountant before doing anything tax-related.

As previously mentioned, the losses incurred from the sum of all expenses relating to the negatively geared investment property may be applied as a tax deduction in their tax return. This allows negatively geared investors to lower the amount of tax they must pay annually.

Purchase Price

The point of negative gearing is to offset losses on your investment property to help you achieve capital gain. So the purchase price of your property is your starting point for figuring out when you will make a profit on your investment.

Rental Income

The next factor in calculating your negative gearing deduction is your rental income. If you're looking to generate a regular income from your property, the rent you charge your tenants will have to outweigh the cost of your home loan repayments. You'll have to balance these costs while remaining competitive with rental prices in the area. It's also important to remember that your home loan repayment isn't the only cost of owning a rental property.

Loan Details

The details of your loan are important because negative gearing allows you to deduct the interest you pay from your income. Many investors choose an interest-only loan, which means they only make payments towards the interest portion of the loan and not the principal amount borrowed. The goal with this strategy is to minimise the repayment and pay off the principal when the property is sold, hopefully for a capital gain. This also works well for negative gearing. The negative gearing concession allows you to deduct the interest you pay on your investment property home loan. If you're only making interest payments, this means you can deduct the entire home loan repayment.

Expenses

After taking into account your home loan repayment versus your rental income, it might at first appear you are positively geared. But negative gearing also allows you to deduct the expenses of maintaining and renting out your property. These expenses include:

  • Repairs and maintenance
  • Pest control
  • Lawn maintenance
  • Council rates
  • Strata fees
  • Property management fees
  • Land taxes
  • Insurance
  • Costs of acquiring tenants

Depreciation

Some items involved in the upkeep of a rental property can't be deducted all at once, but can instead be depreciated over several years. These items are generally anything you've purchased for the property that would decline in value over time. Deductions can also be claimed for improvements carried out on the property. An improvement is anything that would fundamentally change the nature of an item being replaced or would add to the overall value or appeal of the property, such as new curtains or renovations.

You can also deduct for capital works, which are building construction costs. This would be calculated at 2.5% over 40 years from the date construction was completed.

Leverage for Greater Returns

The fourth benefit of negative gearing is that if you actually achieve the capital growth that you want, there is the opportunity to leverage against that in order to get larger returns and to expand your portfolio.

As your property goes up in value, it may be possible to borrow against that increased value to use that as a deposit on another property and expand your portfolio without actually injecting any more cash into these investments.

 

Long-term Capital Growth

By choosing an investment property that is situated in a real estate market that has the potential to increase in value, they may also benefit from the property's potential value appreciation. This capital appreciation may allow them to regain their losses and profit from the property once it is sold.

Property is a tangible and resilient asset. While the market is not constant and regularly fluctuates, property values generally increase over time, and so do rental rates.

An investor who is keeping their negatively geared property may be looking to capitalise by selling when it's value increases or take advantage of higher rental returns in the future. This long-term capital gain often offsets the short-term loss.

Opportunity to Add Value (Almost) Instantly

Benefit number five is the opportunity to add value almost instantly through things like renovations or subdivisions or a bunch of different other ways to add value to a property.

By purchasing a negatively geared property that might be rundown or might have been on the market for too long and therefore you got a great deal you might have the potential to increase value on that property by doing some hard work and making that property more appealing to your target market.

As you can see, negative gearing is a very common investment strategy, and there are some major advantages to it.

Who benefits most from Negative Gearing?

Negative gearing is best suited to investors on a higher tax rate who stand to benefit the most from tax deductions (which are calculated on your marginal tax rate). The higher your tax rate, the bigger the benefit.

Negative gearing is also suitable for those who ultimately want to achieve a capital gain (a profit when they sell) rather than rental yield (income from renting your property). Low-income earners or those seeking to make an income through rental are better to consider positive gearing.

A loss on paper but cashflow positive. How does that work?

Achieving a virtual loss but a real gain is the holy grail of property investing. To do that, you need to be across all the tax-deductible depreciation allowances or have a financial adviser who is. The newer your property, the better the depreciation allowances, as they are calculated on the declining value of new items year on year, and capped at a specific time period. While they don't actually cost you money, the decline in value on paper can make a massive difference to your tax return.

Imagine you have $15,000 in costs for your investment property, but only $10,000 in rent, you have made a $5,000 loss for the year.

On a tax rate of 47%, you would get a benefit of $2,350 by offsetting your loss against your income, but on a tax rate of 19%, you would only realise $950 in deductions.

Now, if you added in depreciation costs, which are simply declining value of new fixtures and not a tangible cost, of $8,000 on a new property (bringing your total losses to $13,000) the benefits for the higher tax bracket investor jumps to $6,110 compared to only $2,470 for the lower tax bracket

Effectively the higher income earner has come out $1,110 in front once depreciation has been added in, while the lower-income earner is still $2,530 behind after the initial tangible loss of $5,000.

It can be confusing, but if you are on a high tax rate, and looking for a long term capital gain on your investment, it is worth speaking with a financial adviser to establish whether property investment would be right for you.

Young are the biggest losers from negative gearing

Negative gearing has not only pushed young people out of the housing market by pushing up house prices but the tax concessions also overwhelmingly go to those over the age of 40. About 70% of the benefit of negative gearing goes to those aged over 40 while just 30% goes to those aged 40 or younger. This represents a double hit for young people. They are missing out on the negative gearing tax concession, and they're being priced out of the housing market.

When Is Losing Money A Good Thing?

Usually, based on the information above, you'd probably want to aim for positive gearing. After all, who wants their investments to cost more than they're making? Property investors in Australia, however, have always seen the positives in putting their assets in negative gearing.

One of the key advantages associated with having a property negatively geared is the potential for capital growth. While negative gearing allows for a short-term gain, property investors may be able to take advantage of a long-term financial boost when the value of the negatively-geared property jumps. For example, if you purchase a property that is negatively geared but is able to sell it for both more than you've paid initially as well as the additional costs, you'll be coming out on top.

Another advantage of negative gearing is the ability to offset that loss against the other income you earn, the most common income source being salary. In this case, your taxable income is actually reduced because of your negatively-geared property, so the expenses related to the property are now being shouldered by rent, tax deductions, or possibly by other forms of surplus cash flow or savings.

 

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