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Tags: Negative Gearing, Property Investment, Tax StrategiesProperty | 16.11.16

Negative Gearing: How does it Work?

“Negative gearing means the amount you’re paying on interest and other expenses is more than the income derived from the property. As a result, you’re making a loss.”

It’s a strategy that allows taxpayers to deduct any losses made on investments from their taxable income and in the early 2000’s it went from a niche activity to the mainstream.

Australia has over 2 million landlords, 60% of who reported a loss in the 2013-14 financial year, resulting in a total of $11 billion in claimed tax deductions.

If you’re making a loss, how is this an attractive strategy?

Besides the immediate tax benefits, the appeal for negative gearing comes from the fact that it allows a property investor greater flexibility compared to positive gearing which is heavily dependent on rental income to outweigh expenses. Because you’re making a loss, for negative gearing to work, over the life of the investment, the capital growth needs to outweigh the loss made.

Common tax deductions that you can claim

An example of how negative gearing works

Assume you have borrowed $400,000 for investment property valued at the same (no deposit). Interest on the investment loan is 6% pa, payable on an interest-only basis. Monthly interest on the loan is $2,000. Your annual salary is $70,000. Other property expenses total $5,000 annually. Weekly rental income from the property is $500.

Salary $70,000
Plus rental income $26,000
Less interest ($24,000)
Less property expenses ($5,000)
Taxable income $67,000
Tax + Medicare levy ($14,662)
NET INCOME $52,338

As you’ll need to cover some of the investment expenses from your employment income, the property can be considered negatively geared. The hope is a future capital gain will recoup these short term losses.

Assumptions:

The above example is taken from Moneysmart.gov.au

What are the main advantages of negative gearing?

The most common reason investors choose negative gearing. By claiming interest repayments and depreciation on the property and fixtures you can reduce your overall taxable income. Speak with a quantity surveyor and an accountant for more information on eligible tax deductions.

Assuming you’ve purchased the right property, the value will increase over time. When selling the property this capital growth will hopefully outweigh any losses made.

Depending on your personal circumstances, using capital growth to build your wealth is arguably a faster way to increase wealth than simply increasing income alone.

Typically, property suitable for negative gearing is located in metropolitan areas and is therefore less reliant on factors such as surrounding employment industries to drive up demand.

Key considerations if you’re thinking about negative gearing

As this strategy requires you to dip into your employment income to cover the cost of the property, it’s not without risk, particularly if you don’t have a reliable source of income or lack a financial safety net. It’s important to budget well and ensure you have enough cash flow to cover unexpected expenses like repairs and maintenance and leave yourself enough to live on!

This investment strategy is heavily reliant on the value of the property increasing. If the value remains steady (or declines!), it will not cover the loss being made, further impacting your cash flow. If you run into cash flow problems you may be forced to sell the property, potentially making a loss.

As negative gearing relies on capital growth it is a more long-term strategy. If you’re planning to sell the property in 3-5 years, this may not be the best property investment strategy.

By reducing your taxable income your loan serviceability will potentially reduce, limiting your borrowing capacity for future investment opportunities.

Negative gearing is great for those who want to benefit from the long-term capital growth of their property investments provided that they have done their research. As is the case with all investments, the choice in strategy should closely match the individual investor's preferences of risk and personal circumstances.

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