Negative gearing

| May 8, 2009

Encylopedia Meaning:

Negative gearing is a form of financial leverage where an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. (When the income does cover the interest it is called positive gearing.)

In Australia, negative gearing usually refers to borrowing for a residential investment (e.g. a house or unit) which is rented out. In most places rents are less than the interest on property value, and the investment thus results negative gearing if the investor borrows, for instance, 80% or 90% of the cost. Loans of up to 100% are possible.

In more simple terms

What is Negative Gearing?

Put simply, negative gearing is a tax benefit offered to investors on their borrowing costs – be it for property, shares or bonds.

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If your borrowing costs exceed the revenue gained from your investment, you are entitled to claim those losses against your total income.

The benefit of gearing is that it allows you to own investments that would normally be out of reach, giving you the opportunity to make a greater return on your outlay.

Taxation  – Negative gearing

  1. Australian tax treatment of negative gearing is as follows.
  2. 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.
  3. Ongoing maintenance and small expenses are similarly fully deductible.
  4. 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.
  5. 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.
  6. 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 then 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.)

Here is how negative gearing works:

Lisa, a property investor, buys a unit for $300,000, putting in $50,000 of her own money and borrowing the remaining $250,000. The interest of 7% each year is $17,500 and the weekly rent is $300 or $15,600 a year.

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Financial flexibility – Negative gearing

Ongoing costs including rates, water, insurance, maintenance and depreciation allowance are $2600 each year. After expenses, income for the year will be $13,000 ($15,600 minus $2600), equivalent to a net rental yield of 4.3%. However, annual interest repayments are $17,500, so she has actually lost $4500 during the year ($17,500 minus $13,000 = $4500).

In this example, the investor can reduce the tax liability on her other assessable income by the investment property’s loss of $4500. If the investor is on the highest marginal tax rate of 46.5% (including the Medicare levy) this tax deduction would have the ultimate effect of reducing the real loss on the property from $4500 to $2408 ($4500 x 46.5% = $2092; $4500-$2092 = $2408). This is a good saving.

If an investor is on a lower rate of tax of 31.5% (including Medicare levy) the after-tax loss on the investment would be reduced from $4500 to $3083 ($4500 x 31.5% = $1417; $4500 – $1417 = $3083). The saving is still quite attractive.

Most people accept a loss in income because they believe it will be more than compensated for by a capital gain down the track. But you need the financial flexibility to fund a cash-flow deficit while the property’s gain accrues. You don’t want to get 18 months into a property investment to find the cash deficit is intolerable.

Compensation need – Negative gearing

The calculations are helped by the fact that long-held capital gains are only half assessable. In addition to the simple income deficit, based on the excess of loan interest over rental yield, the investor also needs to be compensated for what they would have earned if they had simply put their money in the bank.

If they deposited the $50,000 into a bank term deposit at 6% and paid tax they would earn $1605 net. So the investor needs a net capital gain of $4013 ($2408+$1,605 = $4013). For the 46.5% tax payer to net a gain of $4013, the property needs to appreciate by $5228 (4013 divided by (0.5 x 46.5%)). This is equivalent to an appreciation of 1.7%. For the 31.5% tax payer the similar calculation gives 2.1%. What does this mean?

Well, if the property market is flat or only slightly positive, the strategy is no better than putting the deposit in the bank. But if property is appreciating healthily the strategy is sound. Over the long term property prices have tended to stay a little ahead of inflation, which the Reserve Bank strives to keep in the zone of 2%-3%. So normally you could count on enough price appreciation to make it work.

One caveat is to avoid optimistic property markets, characterised by low rental yields and inflated prices. Buying at an inflated price will make the strategy go pear-shaped. The rental yield will be low, necessitating a higher break-even rate of appreciation, but the future price trend from an inflated level is often flat or down, at least in the short term. This is the bind that some investors over recent years have fallen into.

REF:PAUL CLITHEROE MONEY MAGAZINE

Negative gearing  – Is it worth it?
At the end of the day, it’s called negative gearing because it involves a loss. So why would you want to spend more money on your investment than it pays you to own it?

Most investors are willing to accept a loss in income if they believe they will be compensated by capital growth in the future. But you must be able to fund this shortfall while you wait for the investment to appreciate in value.

You also need a taxable income from which this loss can be negatively geared against. And the higher your income, the higher the benefit will be.

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