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Negative Gearing And Its Relation To Income Tax: Does Negative Gearing Reduce Taxable Income?

 

Gearing means borrowing money to buy an asset. And the reason you hear so much about it is that the government's gearing policies have a significant impact on how attractive the property market looks to investors, which, in turn, has a significant effect on everything from the amount of housing available to the average weekly rent.

Gearing is when you borrow money to invest, and it's typically talked about in the context of investment properties. The income earned from your investment property is either positively or negatively geared.

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.

There are plenty of reasons why Australians love to borrow money to invest in bricks and mortar. 

Some people think the value of property never goes down; others like the fact you can see and touch it. But, mostly, it is the ability to offset the cost of owning the property – including the interest paid on loan – against assessable income that makes it particularly attractive.

As long as the loan costs are higher than the rental income, then the Australian Taxation Office allows investors to offset the loss against their income. This strategy, known as negative gearing, is often considered more a tax strategy than an investment one.

What Is Negative Gearing?

Negative gearing is when you borrow money to invest into an asset (usually a property) and the income you make from that investment, i.e. the rent, is less than your expenses, meaning that you're making a loss.

People, of course, invest in properties to make money, and so making a loss is never ideal. But Australian law also allows investors to deduct any losses they make on an investment property from their taxable income, which makes it far more accessible for people to invest in the property market. This is the principal benefit of negative gearing – and one that often leads to an increase in rental housing supply.

A lot of investors who buy properties to rent out to tenants don't expect to make money on the rent. Instead, they buy properties intending to cash in on a property's long-term capital growth. Which is to say, they buy a property in the hope that its value will eventually increase to a point whereby a healthy profit can be made from its sale. 

You won't find the phrase 'negative gearing' in tax legislation.

Suppose the rental return or the rental income is not substantial enough to cover the total costs of managing the rental and re-paying the interest portion of the loan. In that case, the investment property will be 'negatively geared'.

At first glance, a negatively geared property won't sound too appealing to an investor who is ultimately focused on maximising their rental income and paying off both the interest and principal portion of the investment loan in each monthly repayment.

But how can a negatively geared property ultimately put you as the investor in a better financial position?

Generally speaking, a negatively geared investment property can provide potential tax benefits for you as the investor when the time comes for you to lodge your yearly tax return.

This is simplistically how it works:

You own an investment property that costs you $500 per week in mortgage interest repayments. You spend a further $200 per week on council rates and water, property management fees, insurance and repairs. In total, you are paying $700 per week.

Also, you have a depreciation schedule prepared, which allows you to claim $150/week in depreciation losses.

It is a commonly used term used to describe a situation where expenses associated with an asset (including interest expenses) are more significant than the income earned from the purchase. Negative gearing can apply to any investment, not just housing.

Individuals who are negatively geared can deduct their loss against other income, such as salary and wages. This is consistent with the broader operation of Australia's personal income tax system.

Australia's tax system operates on the principle that people pay tax on their personal income, less any expenses (called deductions) in generating that income. This is similar to how business profits (that is, income fewer expenses) are taxed, i.e. tax is levied on the net profit of a business, not its gross revenue.

Deductions for costs incurred in producing income recognise that different people have different values in creating revenue.

Negative gearing property is a popular investment strategy in Australia, but how do you actually save tax by negatively gearing your investment property?

How Does Negative Gearing Help You Save Tax?

There are a lot of investors in Australia who are negatively gearing their properties with the promise that it's going to help them save money on tax and with the hope that they're going to make money through capital growth in the future. But how exactly do you save tax through negatively gearing your investment property?

A property is negatively geared when your rental return is less than your interest repayments and other property-related expenses.

If you're looking to save tax through negative gearing, it's important to understand, how exactly does that work? Why do people do it? And what are some of the risks associated with negatively gearing your property?

The way negative gearing helps you to save tax is by offsetting your taxable income. Now, if that sentence doesn't make sense to you, don't worry, I'm going to explain it. Let's use a very generalised example. Let's say that you earn $100,000 per year from one job.

You just have a job, your employer pays you, and you earn $100,000 per year. You pay a certain amount of tax based on that $100,000 that you earn. And now, that way that tax is calculated in Australia is a tiered system. So the first chunk of money you earn, I think it's like $6,000 or something like that, is tax-free or maybe even up to $18,000. And then, slowly, the more money you make, the more tax you pay. So, after $18,000, I think you're paying around 18% tax or something like that.

Negative gearing is a popular tax minimisation strategy, but remember, you only reduce your tax if you reduce your income. If you are borrowing to invest, choosing a positively geared investment will increase your income and increase your overall return on investment.

And then once you go a bit higher, the tax rate increases to 30-something percent. And then once you go really high and you're earning, I think, it's over $180,000 at the moment; you're paying over 45% in terms of your tax.

 

Now, don't take that as law. Obviously, I'm not 100% on the numbers. But, basically, it's a tiered system so the more you earn, eventually, you end up paying more tax. Of that $100,000, there's a chunk of tax that you need to pay. Let's just, for this example, call it $30,000. Let's just say, across the board, on average, and we're paying 30% in tax. This is going to be super general. So this won't apply to you, it's just so we can get an idea of how this works.

So we're earning $100,000, we're paying $30,000 in tax. But now we have a property. We have a property that is negatively geared by $10,000 per year. So, about $200 per week, this property is negatively geared. What then happens is we take that loss of $10,000, and we mix it with our income of $100,000. So we have an income of $100,000 minus a loss of $10,000 equals $90,000 in taxable income. So, what it means to offset your taxable income means that you're actually taking that loss away from how much income you're allowed to be taxed on by the government.

So, previously, you were taxed on $100,000. And you paid $30,000 in tax, a very general example of 30%. You now lost $10,000, so your taxable income is now only $90,000. And so, your tax on that, let's say it's still 30%, would then be $27,000. So there's a $3,000 difference between if you earn $100,000 or if you earn $90,000. And again, just let me say, a very general example. That $3,000 or that tax refund is how you save tax through negative gearing.

So what negative gearing effectively does is lower the taxable income or what income you say to the government, I earn X amount of dollars per year. Often we simply think of our income as how much money I earn. But really, your income can be a mixture of things and can be multifaceted. So you can earn income from a job that you have employed at. You can earn income on the side, let's say you mow people's lawns, you get paid in cash; that can be income that you're taxed on as well.

You could work as a sole trader or a contractor. You could get stock dividends. You could get income through capital growth, through the selling of a property or the selling of stocks or the selling of another item that's gone up in value. Or you could also generate income through positive cash flow property. But the same is true; you can lose income through positive cash flow property. And so, basically, all of those different things need to be taken into account to work out how much "taxable income" you have at the end of the year. And that's how the government is going to work out your tax.

How Does It Work?

Negative gearing works because your tax bill is reduced by an amount equal to your effective marginal tax rate, multiplied by the excess of deductible expenses over investment income – that is, the tax loss on your property.

For example, if your property rents for $380 per week and in the 2007/08 financial year it is fully tenanted, the resulting rental income would be $19,760. Deductible expenses for that year total $30,000, bringing your net rental loss to $10,240.

hands exchanging house and money

Assuming your net taxable income for that year, excluding the rental loss, is $75,000, the negative gearing benefit from your rental loss will be $10,240 x 30% (the marginal tax rate), or $3,072.

By allowing prospective investors to deduct any losses they make on their investment property from their taxable income, negative gearing makes it possible for a much larger proportion of the population to buy an investment property, much sooner than they would be able to if they had to rely solely on positive gearing. And this can help to reduce rental prices by increasing the amount of rental housing available on the market.

However, for negative gearing to work, investors need a reliable cash flow to cover pre-tax borrowing costs and to earn enough income to meet their loan repayments. And they also need to be in a position to hold onto the property for long enough for its value to increase to a point whereby the profit made on its sale is greater than the rental shortfall incurred during ownership.

Before deciding on which gearing strategy works best for you, we'd recommend speaking to a financial advisor, so that you better understand the potential pitfalls and rewards.

While making a loss on an investment property or shares might initially seem counterintuitive, some people are willing to do this in the expectation that the capital gain (sale price minus the cost of asset) when they sell the asset will more than offset that loss.

Some people might also find themselves unexpectedly in a loss position if they incur higher expenses or lower returns than anticipated.

Only 50 per cent of the increase in the value of the asset (when it is sold) is subject to income tax, providing it has been owned for more than 12 months.

Many non-tax factors drive people to gear property investment negatively – for example, percePtions about the advantages of negative gearing and a bias towards investing in 'bricks and mortar', especially under certain market conditions; both of which might be fuelled by advice from property investment advisers and the media.

The Benefits Of Negative Gearing

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.

A large majority of properties in the Australian economy are negatively geared; they can help keep rent lower and reduce public housing requirements.

Beneficial tax arrangements for investors, and can help grow the wealth of every day Australians.

The main advantage of negative gearing is that you can offset the loss from owning a property with the income you earn from it. This will eventually decrease the taxable income, and your tax liability will decrease. Those who pay high tax may prefer negative gearing when it comes to investing in real estate, as it will increase their tax return and also allow long term capital growth.

What Are The Risks Involved With Negative Gearing?

Just like any investment strategy, negative gearing has risks. Borrowing money to fund an investment is risky in itself, and you should be fully aware of what negative gearing involves before you pursue this strategy. Consider the following risks before you commit to a negative gearing strategy:

  • What if you have a cash flow shortage?
  • What if you can't find a tenant and the property is left vacant for an extended period?
  • What if the property market takes a dive and you are unable to achieve the capital gain you had planned?
  • What if you are unable to make your loan repayments?
  • What if tax laws change and negative gearing are no longer as financially viable for your unique needs?

However, there are steps you can take to minimise the risks associated with negative gearing. The best way to minimise your investment risk is to do plenty of research when choosing your investment property and select a property that is likely to rise in value.

Make sure your income is high enough to cover interest repayments and maintain your investment property, even in less-than-ideal circumstances. Speak to the experts such as a financial planner, a tax accountant and a mortgage broker to ensure that you make a sound financial decision.

The downside of negative gearing is:

  • Tax benefits largely help higher-income earners, and if you aren't paying any tax, then there is no point in getting a discount on it!
  • It can inflate property values making it harder to get into the market if you are a first homeowner.
  • Depending on how negatively geared you are, you could be entirely reliant on capital gains and get into issues if expenses significantly increased.

Is a negatively geared investment property right for you?

When a residential property investor borrows money from a lender to fund an investment property – which is the purchase of a property that will be used as a rental rather than the buyer's primary residence – it becomes open to a financial strategy called 'gearing'.

In other words, the buyer will use the loan from the lender as a means to generate an income, and the government will allow some tax deductions related to owning that property.

If the investment property generates a profit, and these returns are substantial enough to be able to cover the costs associated with the running of the property, including covering the interest repayments attached to the loan, the property will be 'positively geared'. Any income that is earned over and above the costs of running the property will be subject to income tax.

On the other hand, the property can also be 'negatively geared'. This is where the costs of owning the property are greater than the income received. These additional costs can be claimed as a tax deduction against your rental income.

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