Negative gearing at the right time

| June 29, 2009

Expected rises in interest rates are likely to bring a revival in negative gearing of investment properties. Don’t let tax considerations be the deciding factor.

For investors, the after-tax benefits of negative gearing are an important consideration in investment decision-making, even though property is not a tax-driven strategy. Negative gearing helps many taxpayers buy growth assets they could otherwise not afford to fund their retirement, ultimately reducing their dependence on government pensions. In our current environment, that investment decision also includes considering how an after-tax cash flow would look if interest rates were 1–2% higher.

 

By closing some of the gap between rental income and finance expenses, negative gearing partly offsets higher interest rates and makes investing in property relatively affordable, allowing investors to fund an asset whose value remains stable from month to month, yet can be expected to perform well over a seven to 10-year time frame.

In our current low interest rate environment, where firmer residential property yields are close to matching interest rates, some investors see negative gearing as less important because the tax relief on the difference between loan repayments and rental income is diminished – variable interest rates can be as low as 5% and rental yields can be more than 4%.

The surprise change in the federal budget that roughly halved the amount that can be put into superannuation each year has turned the focus back on negative gearing into property as a tax-efficient alternative. Coupled with this structural change in our investment system is the seasonal issue of tax deductions as we approach the end of the financial year on June 30.

Is negative gearing worth re-examining? First things first: negative gearing is a policy that delivers an important avenue for a wide variety of investors to create wealth, helps insulate Australian residential property from wild price swings and maintains relative affordability in the private rental market.

But a word of caution: investors should avoid trying to manipulate the gearing equation and purchase an investment property solely to increase tax benefits. I’ve seen many investors make this mistake in the past decade, leading them to buy assets not suited to investment, such as high-rise apartments or seaside holiday houses. It’s a fundamental, yet easy mistake to make, because as we have seen in the past year, growth outcomes can vary widely across the market.

This finely balanced equation may be true for the time being, but the near alignment between yields and interest rates is unlikely to last, as many commentators, myself included, expect interest rates to start rising within the next year or two. When rates do rise, investors who claim a deduction will be cushioned from some of the increase in repayments.

In a tightening interest rate environment, the accompanying rise in negative gearing’s after-tax benefit helps insulate investors, particularly those with higher borrowings.

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