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Negative Gearing & Property
By definition, negative gearing is where you borrow to acquire an income producing asset and the interest and other tax deductible costs you incur exceed the income you receive from the investment. 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. As the description implies, negative gearing means a negative cashflow that you need to fund from other income sources.
Creating wealth through purchasing an investment property is a well established practice in this country, however, negative gearing can also apply to other types of income producing investments such as shares and managed funds. The attraction of borrowing or ‘gearing' is that you can invest in shares or property that might otherwise have been unaffordable. For individuals, the loss can also be offset against other assessable income and the tax benefit will depend on your marginal tax rate.The real benefits of negative gearing are only realized when you combine the correct tax and financial advice with a property in the right location funded by the most suitable loan product. You should always seek expert professional advice to make sure the purchase is within your budget and will provide long term taxation and financial benefits.
While gearing can amplify your gains, it can also magnify your losses. For example, it is estimated that the 2008 US sub-prime lending crisis left close to 30% of mortgagees with a loan balance higher than the value of their property.
If you negatively gear property, you need to understand some important points:
- Investing in property is usually a medium to long term investment and requires planning. Extra caution must be exercised when a property is projected to generate a negative cash flow for a number of years.
- 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 your losses.
- You have to remember that the family home is a purchase from the heart while an investment property needs to be a purchase from the head. You've heard the old saying that the three most important things when buying a property are: ‘location, location, location' and this is even more important when buying an investment property.
THE TAX CONSEQUENCES
Negative gearing of a rental property can be complex. For example, 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. As such, the right taxation advice can nearly be as important as finding the right property. To broadly illustrate how negative gearing works let's assume you buy a flat or unit for $400,000 in your personal name and borrow $350,000 to fund the purchase. The funds are borrowed at an interest rate of 8% and the weekly rent is $450 or $23,400 a year. Ongoing costs including agent's fees at 7% of the rent, rates, insurance, repairs and maintenance and other expenses are summarised below:
Sample Property Profit & Loss Statement
Rental Income - 52 Weeks @ $600
- Interest - $400,000 @ 5.5%
- Water Rates
- Council Rates
- Repairs & Maintenance
- Agents Commission - 7% of Rental Income
- Bank Charges
- Body Corporate Fees
Net Tax Loss (before Depreciation)
Less: Depreciation (based on Depreciation Report)
Net Tax Loss
So, although the Gross yield is a healthy 5.2% , after annual interest repayments and all associated expenses you have actually ‘lost’ $5,200 during the year, although the actual 'cash' outgoings are limited to $800 as depreciation is a non-cash deduction.
In this example, you will reduce your taxable income by $5,200 through incurring a loss on the investment property. If you had a taxable
income greater than $180,000 in the 2017/2018 financial year you would be on the highest marginal tax rate of 46.5% (including the Medicare
levy) and this tax deduction would have the ultimate effect of reducing the after tax 'cash' cost of the property from $800 to a net annual
positive 'cash' income $1,618 or $31 per week. The tax treatment has turned a cash outlay into a positive cash flow. If you are on a lower
marginal tax rate of tax of 32.5% (incomes between $37,001 and $90,000) the annual cash cost on the investment would be reduced from $800 to
a positive cash income of $890 (or $17 per week). The 2018/19 individual tax rates are:
Tax on this Income
$0 - $18,200
|* The above rates do not include the medicare levy of 2%|
How We Can Help You ...
The real benefits of negative gearing are only realised when you combine the correct tax and financial advice with the right property and loan product. You should always seek expert advice to make sure the purchase is within your budget and will provide taxation and financial benefits in the long run.
- Evaluate the tax consequences - Using an intelligent software tool we can prepare a 10 year cash flow analysis of the proposed property, taxable income forecasts and equity projections. This ‘what if' analysis let's us quantify the financial impact of changes in key variables such as rental income or mortgage interest rates.
- Where to buy - through the services of a buyer's advocate we are able to help you locate the right property in the right location with a view to maximizing the capital gain on sale.
- Finance - through our affiliation with a mortgage broking group we can help you find the ideal loan that is correctly structured for taxation purposes.
- The tax loss on the property can pose a major cashflow issue, however, we can prepare an application to vary your PAYG tax withholding so that your annual tax deductible loss is reflected in your regular pay packet.
- Historically we have found the calculation of capital gains on sale of property to be a source of major headaches and frustration due to the loss of source documents. We can make recommendations regarding your record keeping including recording cost base details for capital gains tax purposes.
If you're looking to accelerate your financial success we invite you to book a free, one hour introductory consultation to discuss how negative gearing might apply to your situation. You'll get practical financial advice designed to help you build your wealth and minimise your tax. To book a time, contact us today on (03) 9326 1244 or complete your details in the box at the top of this page.
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