Negative Gearing - McCarthy Group Negative Gearing - McCarthy Group

Negative gearing is a commonly heard term, but one that makes most people’s eyes glaze over when they hear it. Why? Because it’s not well understood.

The purpose of this Investment Property Update is to explain negative gearing in simple terms, so that the next time it crops up at a dinner party, you can join the conversation!

Negative. Gearing.

These are two words combined into a single term. To get started, let’s split them up to see what each term means, and then put them together again.

    • Gearing

      This is a word used to describe investment, in this case, investment property.

      Gearing arises when:

      The investment is then said to be ‘geared’. Why? Because the amount of money that you had available ($100,000) has been “geared up” by a factor of 5. As a result you have been able to buy an investment property worth 5 times the amount you had available. 80% of the total investment has been borrowed, and you now owe this to the bank (as a mortgage).

      The bottom line is that you have borrowed money to fund a bigger investment. This is called ‘gearing’. Which is probably the way you invested to buy your family home.
    • Negative

      This means the annual return on your investment property is negative. In other words, the investment loses money. Why? Because the costs you pay out are higher than the income the property brings in. The two parts of the equation are:

      • A

        The costs

        • Interest costs on the $400,000 mortgage
        •  Other costs like:
          • Rates
          • Maintenance
          •  Management costs
          •  Property management fees
          •  Landlord’s and building insurance.
      • B

        The income

        •  Weekly rental payments by the tenants
        •  Tax credits.
      So putting the two words together,
      negative gearing results where

      A > B

      i.e. the investment property
      runs at a loss.

      Is a negatively geared investment automatically a bad investment? After all,
      who would want to borrow and invest money in a property, to make a loss?

      The answer? Not necessarily. About two out of every three properties in
      Australia are negatively geared. So there is clearly more to it than meets the eye.

The positives of negative gearing

  • Reduce your taxable income

    In the eyes of the ATO, investment property is a business. You receive income and you have costs. If the costs are greater than the income, the government will allow you to deduct these losses from your other income. They become tax deductible losses.

    In simple terms, let’s say you have a job that pays you $70,000 per annum. If you lose $10,000 on your negatively geared investment property, the ATO allows the $10,000 to be deducted from your income. You then only pay tax on $60,000. So your taxable income has been reduced, and you pay less tax.

    Another way of looking at it is that instead of paying tax on all your income, some of the tax has been diverted to help you fund an investment property. How does that sound to you?

  • Capital gains

    A key reason why some investors choose negative gearing as a strategy is the potential to earn capital gains over the long term of the investment, as property prices increase over time. By gearing your investment, you are able to have a much larger sum working for you, and earn bigger capital gains.

    Let’s compare how your original $100,000 invested at say 5% per annum, compares with your geared $500,000 investment property, with an annual capital gain of 5%.

    All things being equal, this is how the returns compare over the years:

    Both investments have doubled over this period. But the geared investment has delivered a significantly higher return.

So let’s summarise the appeal of a geared investment

  • You had exactly the same amount of capital ($100,000) available to start with.
  • By gearing the $100,000 with a $400,000 mortgage from the bank, you had an investment worth five times
    the amount that delivered five times the return.
  • Plus – if the investment generated a loss – i.e. the investment property was negatively geared, the ATO
    provides you with an income tax benefit.

What about the interest on the mortgage?

With your family home, if you have a mortgage,

  • You pay all the interest costs yourself
  • These interest payments are not tax deductible.

The beauty of the investment property concept is that unlike your family home, you get two sources of funding to support a negatively geared investment:

  • Your tenants pay weekly rental income to you
  • The tax office gives you a tax deduction of the amount of the loss from your income.

The image alongside shows there are three parties meeting the costs of the investment property, with the tax office contributing to the costs because of the loss associated with negative gearing.

Why does the government
provide this tax concession?

The fact that you can deduct the loss associated with a negatively geared investment property provides an incentive and support for investors to get involved in the rental property market.
Approximately one third of Australians do not own their own home, and are therefore renters. This may be because they can’t afford to buy their own home, or because they don’t want to.
Investment property owners fill this gap, and provide the homes for rent. In that sense, it is like a service to the community.
Negative gearing means that the government does not need to become deeply involved in the provision of housing. This funding is diverted so that private investors and the markets can provide the homes instead.

Wouldn’t positive gearing be better?

The short answer is “Yes”. Positive gearing is when the income from the investment property is higher than the costs i.e. the interest costs, rates and taxes, maintenance etc.

However, due to the high cost of property, to get a positively geared property from day one means that you have to either:

  • Put down a much larger deposit – meaning a smaller mortgage is needed, with lower monthly interest
    payments.
  • Find a cheap property in an area where capital gains are unlikely, but that can be leased for a fairly high
    rental.

Realising that the above are not always possible, the government provides tax benefits for negative gearing so that you can buy an investment property (and make it available for renters) that you otherwise could not afford.

Negative gearing is not forever

This is because in the same way that property prices increase over time due to inflation, wage increases etc., so do weekly rentals. Therefore, as the rental increases, the negative gearing loss reduces, and the tax benefit reduces as well.

Other drivers of rental increases are our rapidly growing population, and the fact that over the past 10 to 15 years, a housing backlog has developed, meaning that the demand for homes is higher than the supply.*

On the cost side, variations in interest rates also affect the economics of the investment. Right now we are enjoying record low interest rates, which brings interest costs down. The reverse happens when interest rates increase.

* Keep a lookout for our future Investor Guide – Why Land is so Expensive.

ITWV – government support for your cash flow

Of great importance and appeal is that while the government gives you a tax credit on an investment property loss, you do not have to wait the whole year to receive the refund.

Instead, you are able to complete an Income Tax Withholding Variation

(ITWV). Once approved, the ATO authorises your employer to reduce the amount of income tax they withhold from each pay packet. In other words, you pay less tax every pay period, which gives you the cash flow needed to support your investment property.

Keep a lookout for our forthcoming Investor Guide on ITWV’s and how they can help your cash flow.

Why don’t more people use the benefits of negative gearing
to buy investment properties?

This is a question I ask myself every day! It is a fact that 90% of Australians will be under-funded in their retirement years, and will have to fall back on the age pension to survive.

We also know that when you take your pay packet, and deduct tax and your mortgage costs, you only have about one-third left for all your other expenses. That makes savings almost impossible, and prevents you from being able to afford the things you would like to do in the future.

Keep a lookout for our forthcoming Investor Guide on ITWV’s and how they can help your cash flow.

Examples of possible life goals

  • Support your kids’ education
  • Provide support so they can buy their first home
  • Have an overseas holiday
  • Buy a new car every few years
  • Be able to meet the medical bills associated with aging
  • Enjoy financial freedom and independence.

In our experience investment property can help you to achieve these goals, and build your family assets. And the negative gearing concept enables you to become a landlord and buy an investment property that you might otherwise not be able to afford.

Other factors that could hold people back

  • A lack of understanding of how it all works
  • The fear of the unknown, or of making a mistake
  • Not knowing how to choose the right type of
    property and location
  • The worry of managing the investment
    property
  • The fear of getting bad tenants
  • Fear of taking on debt
  • Fear of taking on more responsibility
  • Not knowing where to get the right investment
    advice.

At McCarthy Group we can help you work through any issues that might be holding you back from growing your wealth.

Breaking away
from old conditioning
is never easy – it takes

courage

Ilvana & Malcolm Odell, investors since 2010

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In Summary

At the end of the day, negative gearing will not suit everyone. However, the purpose of this investment property advice is to help you to understand the concept, to see if it makes sense and whether it could work for you.

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