Negative Gearing Explained By Zelko Maric What Is Negative Gearing? Negative gearing refers to the borrowing of funds to pay for a home which the buyer then rents out. As rental income is usually less than the cost of the interests and outgoings paid on the property the investment is considered to be “negatively geared”. The attraction of borrowing or ‘gearing’ is that you can invest in shares or property that might otherwise have been unaffordable. Negative gearing tends to be adopted as a financial strategy for two main reasons: A negatively geared property can offer immediate tax benefits while also offering the prospect of capital appreciation over time. Negative Gearing and Tax Benefits In Australia investors are allowed to offset an income loss incurred on a real estate investment against another form of income. An income loss takes place when the property holding costs are higher than the rental income from the property. The upside is that you are expecting a potential capital gain that will ultimately be worth more than a definite loss of income. Negatively gearing a property can be very complex. Some expenses are not deductible (stamp duty, initial repairs etc.) while other expenses such as borrowing costs and depreciation are generally claimed over a number of years. Interest on the investment loan is fully tax deductible. Hence if the rent you make on the property in the first year leaves you a couple of thousand dollars short, you can “save” money off your tax bill by deducting the interest spent from your total earnings (salary, wage or rental income). This reduces your overall tax debt as it reduces your taxable income. Other deductions are also allowed but things can start to get more complex when the property is sold. One deduction is for depreciation. Another is for capital works. (Capital works receive a deduction of 2.5 percent per annum on the initial cost). At the time of selling, capital gains tax must also be paid on the proceeds minus cost base, not including items such as property fixtures and fittings. (These fittings can receive a deduction for depreciation though). Once all the various deductions are taken into account, the net capital gain is taxed as income, but if the property has been held for a year it is then discounted by 50 percent for an individual, or 33.3 percent for a super fund. The key thing to realise is that if the property is costing you more to hold than it is generating for you, you will have to cover the gap from your own pocket until the income from the property rises or the expenses on it reduce. ZELKO MARIC 03 9328 4722 http://www.ybg.com.au Perhaps for this reason, negative gearing is often used by higher income earners to reduce their actual taxable income in the short term and make capital gains over time. An Example As an example of how negative gearing works let’s assume you buy a property for $300,000 in your personal name and borrow $250,000 to fund the purchase. The funds are borrowed at an interest rate of 8% and the weekly rent is $300 or $15600 a year. Ongoing costs including agent’s fees at 8.5% of the rent, rates, insurance, repairs and maintenance and other expenses are summarised below: This example suggests the net income for the year will be $14274 ($15600 minus $1326), equivalent to a net rental yield of 4.75%. However, annual interest repayments are $20,000, so the tax deductible loss is $5726 for the year ($14274 minus $20000). Assuming you own the property in your own name, the loss will reduce your taxable income by $5726. This reduces the cost of holding the property. Some Important Points Must Be Considered While gearing can magnify your gains, it can also amplify your losses if the price of the property falls leaving you with a loan balance higher than the value of your property. Negatively geared properties are expected to generate profits only through Capital Gains and there is no guarantee that the value of the property will appreciate enough during the holding period to cover all your losses. Investing in property is usually a medium to long term investment and requires careful planning particularly when a property is projected to generate a negative cash flow for a number of years. Negative Gearing isn't suitable for all investors and the tax benefits should not be the only reason for the property purchase. Although it can lower your tax liability, the tax implications will depend on your personal situation and the type of investment you choose. Negative Gearing implies a negative cashflow that you need to fund from other sources. We have a comprehensive booklet available to clients; ‘The Complete Guide to Negative Gearing & Property’ that explores what expenses is deductible, what costs need to be apportioned and which costs are non-deductible. It explains how negative gearing works for tax purposes and what costs form part of the cost base for capital gains tax purposes. It guides you through what we describe as the 13 steps of negative gearing and is available free of charge to our clients in conjunction with a negative gearing consultation. ZELKO MARIC 03 9328 4722 http://www.ybg.com.au Conclusion Many assumptions must be made in this area. Interest rates, maintenance, capital appreciation, as well as future tax rates all need to be carefully thought through. Some people would say the only thing guaranteed is the loss of money, if only initially. Furthermore, it’s not that you don’t avoid paying tax but rather simply defer the debt until you sell the property, when depreciation savings become subject to capital gains tax. Hence you must keep in mind that if something has tax advantages it is for a very good reason. Negative gearing will build wealth for you if there is a rapid price increase in the property market but you will have to work extremely hard to get the benefit. Having a steady cashflow that can comfortably meet the gap is also important or you could find you are over-exposed. Hence negative gearing is not an easy option – before you embrace it make sure it is a strategy that suits your goals and situation. How Yarra Business Group Can Help You WE help you evaluate the tax consequences – We prepare a 10 year cash flow analysis of the proposed property, taxable income forecasts and equity projections. This scenario analysis lets us quantify the financial impact of changes in key variables such as rental income or mortgage interest rates. How and Where to buy – We have the expertise to help you locate the right property in the right location with a view to maximizing the capital gain on sale. Finance – Not all loans are the same. Because everyone’s circumstances are different particularly from a tax point of view we help you find the ideal loan that is correctly structured for taxation purposes. Since the tax loss on the property is a major cashflow issue, we can prepare an application to vary your tax withholding so that your annual tax deductible loss is reflected in your regular pay cheque. Structure: Are you structured correctly? Can someone sue you and seize your property after many years of capital appreciation? We ensure that you are structured correctly both from a protection perspective as well as from a tax minimisation perspective. ZELKO MARIC 03 9328 4722 http://www.ybg.com.au .