Whether you’re a seasoned investor or a newbie, having a clear grasp of what negative gearing is may work to your advantage.
Negative gearing is when you buy an investment property and the costs of your mortgage repayment and property management and maintenance are greater than the rent you get, resulting in a loss. You then must supplement this loss with another source of income such as your wages.
For example, you incur $40,000 in expenses on your rental investment, but your rental income is only $25,000 annually. Your shortfall would be $15,000 negatively geared.
On average, an investor makes a loss of almost $9,000 a year, according to the Australian Taxation Office. It doesn’t sound like losing such a huge amount of money is a good strategy, but many people still do it – and here’s why.
Negative gearing has advantages that may be beneficial to you, your property investment and your overall wealth position. Some of these are:
- Potential capital growth. The goal with a negatively geared property is to find a well-located dwelling in a sought after area, which has strong capital growth potential. This way, you may also be able to take advantage of its long-term growth prospects, which will ideally make up for the financial losses incurred along the way.
For example, if you purchase a property that is negatively geared but that grows in value at an average rate of 8% per year, then you stand to make a hefty profit.
If you’re in it for the long haul, you may be willing to accept a cash flow loss in the short-term and anticipate a larger capital gain in the future. However, keep in mind that this carries a risk—the future capital gain is only a possibility, not a sure thing, says Simon Buckingham, a professional investor with over 15 years of experience.
- Offset losses. Negative gearing may also help you offset losses against other income you earn, the most common income source being your salary. Your taxable income may be reduced because of your negatively geared property, with the tax deductible expenses related to the property including mortgage interest, council rates, property management fees and insurance.
- Tax deductions. Following on from above, investors using a negative gearing strategy can deduct their loss against other income such as salary and wage, consistent with the broader operation of Australia’s personal income tax system.
Taking the earlier example, you incur $40,000 in expenses on your rental investment, but your rental income is $25,000 annually. Your shortfall would be $15,000. Say you have an annual income of $120,000; the $15,000 will be taken off your income, resulting in your taxable income being only $105,000. You would then get a tax refund on the tax paid between $105,000 and $120,000.
There are three types of deductions:
- Revenue deductions. These include mortgage interest, maintenance expenses, and recurring costs such as property management fees, advertising fees and insurance. These are all deducted from the investor’s income for the current year in which the expense is incurred.
- Claims for capital items subjected to depreciation. For this type of deduction, a property investor must claim the cost over a longer period of time, rather than doing it all at once.
- Claim depreciation of capital works. Capital works are construction expenditure used to produce income. Some examples of these are:
- building construction costs
- the cost of alterations, such as removing or adding an internal wall
- major renovations to a room
- adding a fence
- building extensions – for example, adding a garage or patio
- structural improvements – for example, adding a gasebo, carport, sealed driveway, retaining wall or fence
Take note that there are expenses you cannot claim. According to the Australian Tax Office (ATO), some of these are:
- Acquisition and disposal cost of the property
- Expenses that are not related to the rental of a property, such as
- expenses connected to your own use of a holiday home that you rent out for part of the year, or
- costs of maintaining a non-income producing property used as collateral for the investment loan
- Travel expenses to inspect a property before you buy it
When you are claiming deductions against your investment property, the principal of the loan is not tax deductible, Chan & Naylor co-founder and non-executive chairman Ed Chan told Your Investment Property.
Negative gearing comes with risks that you must be aware of as an investor. If you do not have a substantial amount of income, investing in a property using a negative gearing strategy may not be the best of options. Keep in mind that you still record a loss with this strategy—it’s best to plan about the worst scenarios that may occur.
Investing purely for tax purposes only is also a no-no, according to Chan.
“Often people will say ‘Oh, I’m saving tax on this so I’ll go and buy a property’. That should not be a reason why you invest,” he says.
“The reason that the tax refund is good is because it reduces the cost of holding the property, and the thinking behind it is if I have got to pay a thousand dollars a week in tax anyway, then if I go into a negatively-geared property, I can redeploy some of that money into the property instead of sending it all to the tax man.”
Unless you have the means to fund any shortfall, investing in a property just for tax purposes may not be ideal.
There are many things you can do that may minimise the risks associated with negative gearing. As a rule of thumb, you must make sure to choose your investment property wisely.
Additionally, you may want to ensure that you have a substantial income as a buffer to cover any late rent payments, repair and maintenance, or if your property becomes vacant over time.
Insurance is also important to protect yourself and your investment property from worst case scenarios.