Ever wanted to have the ins-and-outs of negative gearing explained to you? Given the current policies in place, negative gearing is a hot topic and has become one of the most popular forms of investments in Australia, so it’s important to understand how negative gearing works.
What is Negative Gearing?
Negative gearing is a type of financial investment where an investor buys an income-producing asset such as property and the cost of owning the asset is more than the income it generates.
Seemingly counter-intuitive, the attractiveness of negative gearing lies in the tax concessions and capital gains investors can benefit from.
How Does Negative Gearing Work?
Negative gearing is an investment strategy in which you purchase a property knowing that your expenses (mortgage repayments, interest, insurance, maintenance and other costs) will be more than the rental income you earn. The benefit of this strategy is to reduce the amount of tax you pay on your personal income each year and to make a profit when you decide to sell the property (capital gains).
The reason why negative gearing can give you a discount on tax is because you are able to claim the losses as a tax deduction. An example of a negatively geared investment might look like this:
Once this loss is offset against personal income, it can be used to reduce the amount of tax paid. For example, if this person’s annual personal income is $100,000, after the investment property loss is offset against it their new taxable income will be $92,200.
The depreciation cost will not remain the same every year, since the expenses you pay to improve or maintain the property will usually not need annual repair. An accountant can help you calculate your annual depreciation cost.
Pros and Cons of Negative Gearing
Negative gearing was introduced to increase property investment and consequently boost house building and expand the housing supply. However, there are concerns as to whether or not it is achieving this goal since most negative gearing investments go towards already existing properties.
Negative gearing has both benefits and limitations for an investor, despite being one of the most popular investment strategies.
Benefits of Negative Gearing
The benefits of negative gearing for an investor include:
- Tax savings: You are able to deduct the losses from your investment from your taxable income, giving you a discount on your taxes.
- Capital gains: Ideally, you will purchase a property that increases in value over time and allows you to collect a profitable sum when you decide to sell.
Limitations of Negative Gearing
Some of the disadvantages of negative gearing for an investor include:
- Reduced cashflow: You will not be receiving any passive income from your investment since you’ll be making an annual loss. This can be a problem if your income becomes less stable or if you can’t get a tenant in for a while.
- Capital loss: A negative gearing strategy can make you more reliant on capital gains and vulnerable to losses if things don’t go as planned. If the market fluctuates or something happens in the area that causes it to decline in value then you might not end up making the profit you’d hoped for.
- Tax benefits help high income earners: This strategy mostly benefits those who pay a lot in tax. If you don’t pay a significant percentage of your income in tax then you may benefit more from a positive gearing strategy.
What Can You Claim On Negative Gearing
You can claim tax deductions on any costs associated with managing and maintaining the property (including depreciation costs) as well as the interest you pay on loans.
The expenses that you can claim tax deductions for include:
- Large capital items and fittings (e.g. a plumb in dishwasher)
- Cleaning services
- Real estate fees and the costs of advertising for tenants
- Accountant’s fees
- Gardening and lawn mowing
- Pest control
- Land tax
- Council and water rates
- The interest on your mortgage repayments
For a full break down, check out our tax deduction guide for investment properties.
Risks to Consider Before Picking a Negative Gearing Strategy
While negative gearing can be an appealing strategy for tax benefits, there are a number of potential risks and pitfalls. Any investment carries risk, but since you will be recording a loss by purchasing a property that is negatively geared you may be more vulnerable to unexpected changes in your financial situation. Some of the risks you should consider before committing to a negative gearing strategy include:
- What if you have difficulty finding tenants to fill your property for a period of time?
- What if the investment doesn’t increase in value or the market takes a turn and you are unable to achieve the capital gain you expected?
- What if there is a spike in interest rates on your mortgage repayments and you’ve already agreed not to raise rent for your tenants?
- What if tax laws change and you are no longer able to save as much on tax as you had previously?
- What if your circumstances change and you are unable to make your loan repayments for a time?
In order to minimise the risk associated with a negative gearing investment strategy, make sure you do plenty of research before purchasing the property to give yourself the best chance of filling it with tenants and making a capital gain. You should also make sure that you will be able to manage your finances even with the losses. Plan for a worst case scenario and speak to a financial planner or accountant to ensure that your calculations are correct.
Negative Gearing Example
To illustrate the power of this policy, let’s look at an example.
Imagine Tom earns a salary of $80,000 a year. One day, he decides to buy an investment property worth $400,000, so he borrows $400,000 with a 6% investment loan interest rate ($24,000 a year). The property’s yearly expense is $5000, and the rental income is $500 a week (or $26,000 a year).
Therefore, Tom’s property is actually running at a $3,000 loss before tax, as he pays $29,000 in total expenses yet only receives $26,000 in rental income annually. However, thanks to tax incentives, Tom actually pays $1035 less tax when he holds the investment property through negative gearing.
Therefore, whilst his net income does decrease annually by $1965, he now holds a $400,000 property that could grow significantly in value over time in a strong market.
If Tom were to sell his property for more than he paid for it, he would make a capital gain. Capital gains are taxed by the government, but if Tom were to hold onto his investment property for more than 12 months before selling it, he could be eligible to only pay half the capital gains tax.
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Negative Gearing vs Positive Gearing
A positively geared investment occurs when the income generated through rent is greater than the expenses paid for the maintenance and upkeep of the property, including the mortgage repayments. This means that the investment is regularly making a profit for the owner.
In Australia, positively geared property generally exists in rural areas where the property prices are low and there is a high rental demand. While not uncommon, positively geared property can be harder to find and offers no tax incentives like negative gearing.
For more information, check out our complete breakdown on positive gearing and instances where investors may benefit from this property investment strategy.
What’s the Best Option For My Investment Property?
The best investment strategy for you will depend on your income and other assets, your capacity for risk, your taxes and expenses and the range of properties that are available at the time.
It’s a good idea to speak to an accountant or financial planner before making your decision and do thorough research on the property you plan to buy. You may also find it helpful to use online resources, such as a guide on how to buy an investment property.
When was Negative Gearing Introduced in Australia?
The legislative reforms that allowed for negative gearing were introduced in 1985 by the Hawke/Keating government. From this point onwards, investment property expenses could be used to offset personal income and reduce tax on said income. These reforms were intended to encourage investing, supply housing and motivate more house building. They were also intended to stimulate the economy through construction and the housing market.
Some changes to the negative gearing policy in Australia have been suggested in recent years, mainly by the Labor party, but none have been passed.
What are the impacts of negative gearing on the property market?
Current policies making negative gearing easy are arguably unhealthy for both the Australian property market and the economy. They incentivise high-end investors to purchase more property, pushing up house prices and reducing affordability for the average Australian.
A 2015 report by the Australian Council for Social Services found over 90% of approved loans go towards existing investment homes. This means broader home ownership rates are reduced, and there’s nothing done to increase supply.
So what would things look like if these tax policies were abolished? A quantitative study recently presented to the Reserve Bank of Australia found some staggering economic impacts. It found not only would house prices soften by 1.2%, but up to 75% of households would be able to own their homes and there would be an overall welfare gain of 1.5% GDP.