What Negative Gearing Could Mean To You
Many people allege that negative gearing is at least partially responsible for Australia’s astronomical housing prices which prevent many first home buyers from entering the market while cashed up investors reap the benefits.
Without the doubt, “gearing”, negative or otherwise, has a significant impact on Australia’s property market. It can affect everything from rental and housing prices to housing stock and even the rental vacancy rate. But what is exactly is gearing?
Gearing means borrowing money to buy an asset such as a real estate property, and the asset can be considered negatively, neutrally or positively geared. Using a real estate property as an example:
- Negative gearing means that rental expenses, including the interest you pay on a loan, are more than rental income a property generates in a year. As a result, you are making a loss. Under current taxation law, this loss may be offset against other taxable income included in your tax return;
- Neutral gearing means that rental expenses are equal to rental income; and
- Positive gearing means that rental expenses are less than rental income. In this situation, you are making a profit. Under current taxation law, this income may be considered income for tax purposes and is included as taxable income on your tax return.
So why is negative gearing a good thing if its means you are making a loss?
Losing money doesn’t sound like a good start when you’re getting into the property market. But it is quite common for most real estate properties to be negatively geared. So, where is the benefit here?
The benefit comes from the capital growth of the property. The property you purchase will hopefully increase in value over the years, and the aim is to have capital growth greater than the net rental losses incurred during the ownership of the property.
Capital growth is not taxed as it happens but instead is assessed when the property is sold and the underlying profit realised. Any capital growth will be included as income for tax purposes but may be eligible for a 50% gain reduction if the underlying asset is held for longer than 12 months.
Is negative gearing the right way to go?
Negative gearing often results in a net rental loss to the investor but this may provide tax advantages. Investors can usually deduct any net rental losses from their other assessable income contained within their tax returns.
Capital growth sometimes acts as an incentive for investors to borrow money in order to buy property with a view of making themselves more financially independent in retirement. Borrowing can also make it possible for those who don’t have a whole lot of money in their pockets for a deposit. Investors can borrow most of the purchase amount and then rent the property out to pay most of the interest and costs off.
Negative gearing is a concept with a risk and is only beneficial when the total return on investment (which includes the capital growth and rent of property) covers or exceeds the total cost.
The following is an example of a negatively geared investment
Lisa buys a unit for $300,000. She puts down $50,000 of her own money and borrows the remaining $250,000 at a rate of 7% per annum over 30 years. For simplicity, let’s say total interest for the year is approximate $17,500, and let’s assume weekly rent from the property is $300 or $15,600 a year.
Other expenses on the property can include, but are not limited to water rates, council rates, insurance premiums, repairs and maintenance, and depreciation on capital assets and capital works. Let’s assume these other expenses on Lisa’s property total $2,600 a year.
Considering only Lisa’s other expenses, net rental income for the year will be $13,000 which is equivalent to a net rental return of 4.3%.However, annual interest repayments are $17,500 so Lisa has actually made a loss of $4,500 during the year.
Lisa can include the rental property’s net loss of $4,500 in her tax return and have this offset against her other assessable income. If she is at the highest marginal tax rate of 46.5%, the tax savings from deducting her rental loss would have the ultimate effect of reducing the rental property loss from $4,500 to $2,408.
Lisa’s property will then hopefully increase in value over the years. For example, if Lisa incurs a rental loss similar to the above each year for 15 years, and she then sells the property for $600,000, she has made an overall gain on the property despite making a loss on the property every year she owned it.
This is a prime example of someone accepting a loss in income “for now” because it is believed that the losses will be compensated by a capital gain down the track. However, it is important to note that you need to have the cash flow and financial flexibility to fund a rental deficit while the property grows in value over time.
Want to know what a negatively geared investment could do for your business? Please don’t hesitate to contact our experienced Newcastle commercial lawyers at Butlers Business and Law on (02) 4929 7002 or fill out an enquiry form on our website.