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Negative Gearing
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Negative gearing
Negative gearing
What is negative gearing?
Negative gearing is when you borrow money to invest into an asset and the income you make from that investment, i.e. the rent, is less than your expenses, meaning that you’re making a loss. Australian law also allows investors to deduct any losses they make on an investment property from their taxable income, which makes it far easier fro people to invest in the property market. 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 with the intention of cashing in on a property’s long term capital growth. Negative gearing creates a tax loss, which can be offset against a taxpayers’ other income, to reduce taxable income and hence tax paid. However, due to the high level of debt against the property, the disadvantage is that the cash received from the rent will not be enough to cover the expenses and any principal loan repayments, so the taxpayer will need to fund the difference.
Example of negative gearing
Say a property investor earned a salary of $100,000 pa last financial year, received rental income of $20,000 and incurred $30,000 in investment related expenses during the year. The investor’s total income of $120,000 is offset by expenses of $30,000 thus reducing their taxable income to $90,000 which is a gross loss of income of $10,000 when compared to their salary. This reduction in taxable income of $10,000 however means the investor would be liable for income tax and the Medicare levy based on $90,000 not $100,000 which would in turn mean their actual cash flow loss for holding the investment would more like $5500 for the year as they would receive a tax credit of around $4500.
Why do people buy negatively geared property?
Firstly, the income received from rent is only a portion of the total return, the other being capital gains. Assuming the investor above purchased the property in question for $500,000 an increase of only 1% or 2% in the property’s value would mean the cash flow loss for that year would be offset by the properties capital gain. Secondly, over time it is assumed that rental income will increase to eventually make the property cash flow positive.
Is negative gearing a good idea?
- Negative gearing can be a good idea when you have enough disposable income to afford the property. This means you’re probably earning a decent wage and you have enough disposable income that you can afford to hold the property and pay for the losses without going deeper into debt and without going bankrupt. You generally need to be able to hold the property long enough for it to go up in value. You need to be able to afford the repayments that you need to make
- It can also be a good idea if you want to save on tax. This generally works for high income earners who pay 40% plus on tax. You should also take into account depreciation of assets and so forth. You can get big tax refunds that could possibly turn a negatively geared property into a positively geared one.
- If the property and rental values are set to increase, negative gearing can be beneficial. This is because you would be getting the benefit of capital gains and that’s going to be greater than the amount of money you put into it.
- It can also be good if rental income is going to go up because it could then move from a negatively geared property to a positively geared property as the rents increase.
When is negative gearing a bad idea?
- Negative gearing is a bad idea if you don’t have a large disposable income to invest. Spending hundreds of dollars a week on a negatively geared property could break the bank if you’re already living below the line.
- If the property and/or rental value isn’t set to increase. If the property value isn’t set to increase, you will miss out on crucial capital gains and end up losing money. Furthermore, if the rental value isn’t going to increase, then there is no way of increasing the equity.
- If you are seeking to invest for passive income, negative gearing can be a bad idea.
What is going to happen to negative gearing?
Ahead of the 2019 election, negative gearing was a key election issue. The Australian Labour Party announced they would support a policy that largely abolished negative gearing tax refunds but since then, no legislation has been put in place.