What is Negative Gearing?
So what exactly is Negative Gearing?
How can Negative Gearing help when investing in the property market within Australia?
Lets have a closer look at how Negative Gearing can help generate you wealth through maximising your Savings.
What is negative gearing?
Negative gearing is a form of financial leveraging, in which an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. (If the income does cover the interest it is called positive gearing.)
A negative gearing strategy can only make a profit if the asset rises in value by enough to cover the shortfall between the income and interest which the investor has to pay. The investor must also be able to fund that shortfall until the asset is sold on the market. The tax treatment of interest expenses and future gain will affect the investor’s final return aswell. Tax rules vary from country to country, and currently only Australia, Canada and New Zealand allow for this tax deduction known as Negative Gearing.
Tax benefits
The Australian Taxation Office (ATO) allows property investors to offset an income loss (where property costs are higher than property income) incurred on a real estate investment against any other income.
Australian tax treatment of negative gearing is as follows;
- Interest on an investment loan for an income producing purpose is fully deductible, even if the income falls short of the interest. Any shortfall ends up offsetting income from other sources, such as the wage and salary income of the investor.
- Ongoing maintenance and small expenses are similarly fully deductible.
- Property fixtures and fittings are treated as plant, and a deduction for depreciation is allowed, based on effective life. When later sold the difference between actual proceeds and the written-down value becomes income, or further deduction.
- Capital works (buildings or major additions, constructed after 1987 or certain other dates) receive a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is on the initial cost (or an estimate), until exhausted. The investor’s cost base for capital gains tax purposes is reduced by the amount claimed.
- On sale, capital gains tax is payable on proceeds less cost base (and excluding items treated as plant above). A net capital gain is taxed as income, but if the asset was held for 1 year or more than the gain is first discounted by 50% for an individual, or 33 1/3% for a superannuation fund. (This discount commenced in 1999, prior to that a cost base indexing and a stretching of marginal rates applied instead.)
Risks involved in negative gearing
Investment income risk
If the investment income is lower than expected or does not grow as expected, the negative cash flow will be larger than expected and continue for longer. Negative cash flow needs to be covered by income from other sources (usually salary).
Risk of capital loss
If the capital value reduces, and the investment is sold, the proceeds may not cover the loan. The remaining loan balance may need to be repaid from other assets.
Interest rate risk
Interest rate on the loan may rise, increasing the negative cash flow needing to be covered from other sources. This risk can be managed by using fixed rate loans.
Income Risk
Income from other sources (generally salary) is needed to cover living costs as well as the negative cash flow. Salary may be reduced if overtime, sales or other bonuses are reduced or income ceases because of redundancy, sickness and injury, or death of the investor or their partner. Income and living costs can change following the ending of a relationship, separation or divorce. Many of the risks arising from a reduction in income can and should be fully covered by insurance – the insurance can be held either personally or within superannuation. Insurance should cover death, permanent disablement and temporary disablement. Insurance should cover the investor, but it should also cover the partner as a significant change in the partner’s circumstances will normally also significantly change living costs and the surplus cash flow available to cover negatively geared investments. It is strongly recommended to have Income Protection insurance before committing into investment in order to make sure the cash flow will be maintained at the event of temporary disablement.
Crucial negative gearing points
- It’s just assumed that you’ll make money from buying a negatively geared property, provided you can hold on for the long-term and wait for the escalator of property prices to steadily rise.
- In times of rapidly rising prices this is great, but in times of stagnant or even falling prices then negative gearing is a poor strategy.
- It’s true that you won’t lose unless you sell… if you can hold on for the long-term and ride out any bumps then you should do well because property prices generally trend upwards (meaning that the average property will increase in price over time.)
- The real losers are investors who buy in the boom and have to sell in the gloom because they can’t afford to ride out the storm.
- Through clever investing and understanding the benefits of negative gearing, one can generate wealth using their savings within the Investment property Market in Australia.
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