Perfect example of Negative gearing

| May 11, 2009

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.

To explain how this works we need to work through the numbers based on a typical property (note: tax calculated based on 2003 tax rates).

gearing

John is a taxpayer earning $80,000 per annum (plus superannuation) in a contract job for a major IT company. He is thinking about purchasing a property for $230,000 (inclusive of $7,850 in closing costs). To maximise his available tax deduction he has been able to secure 90% finance on a 25-year principal and interest loan with a current variable interest-only rate of 6.7% per annum. He makes weekly loan repayments in advance. The developer has offered a 5 year rental guarantee at $250 per week. The rates and body corporate fees total $2,000 per annum and there’s also an 8% rental management commission to be paid. We are going to ignore depreciation benefits for the time being. At the end of the first year, the profitability of John’s property investment would be:

Rental income
$13,000

Rental Management
($1,040)

Loan Interest
($13,869)

Rates etc.
($2,000)

Total
($3,909)

John is then able to claim the loss of $3,909 against his salary income and can reduce his overall tax bill as follows:

John with
no property

John with
one property

Salary
$80,000
$80,000

Property tax loss

($3,909)

Taxable income
$80,000
$76,091

Tax + Medicare
($26,180)
($24,284)

Nett income
$53,820
$51,087

Even though John has made a loss of $3,909, the after-tax effect on his bottom line income is only $2,013 ($53,820 – $51,807).

Are you wondering that given this investment was going to lose money, then why on earth would John want to buy it?

Good question! Trying to explain a good answer raises several key issues at the heart of negative gearing that must occur before you’ll make one dollar in profit.

The short answer is that John is speculating that his potential capital gain will be consistently more than his certain income loss.

Which isn’t out of the realms of possibility given that all he seemingly needs to make is capital appreciation of just 0.88% ($2,013 / $230,000) per annum to at least break even.

Indeed, if John had’ve purchased this property back in 1996, then it’s extremely likely that he would be sitting on a small gold mine right now.

But trying to examine John’s intention for investing actually opens up many other issues that must also be considered to paint the full picture of his investment – now and in the future. Let’s now examine some of those issues…

Can you make money and save tax at the same time?

At any given point in time you can’t make money AND save tax because the act of making money gives rise to the need to actually pay tax.

This is where we need to discuss the difference between a realised and an unrealised profit/loss.

In negative gearing the loss is real in that John will physically have to come up with the after tax shortfall of his expenses over his income. This can be summarised by:

Property loss
($3,909)

Tax benefit @48.5%
$1,896

After tax loss
($2,013)

The consequences of this are that John will physically lose the buying power of $2,031 out of his pocket until expenses fall and / or income rises. In pre-tax dollars, the $2,013 equates to 5.19% (($2,013/48.5%)/$80,000) of his salary that he has lost from owning this property.

On the other hand any of his capital gains remain unrealised, and as such there is no tax to pay, until he decides to sell.

John can even refinance any capital appreciation he obtains and effectively pay no tax provided he doesn’t sell!

But the problem with an unrealised gain is that you can’t generally use it to fund your lifestyle. For example, you can’t go into the supermarket and pay for your groceries using your capital gains debit card.

Accessing your unrealised profits can also be expensive (with redraw fees) and time consuming (with forms to fill in and sometimes lengthy delays).

Contrast the situation of realised loss and unrealised gains (as discussed above) with cashflow positive property that has only realised income gains.

Because your property income is higher than your property expenses then you’ll have to actually pay tax on your profit.

For example, imagine John purchased a property that had the following annual outcome:

Property income
$12,000

Property expenses
($10,000)

Subtotal
$2,000

Tax payable @48.5%
($970)

After tax profit
$1,030

Unlike the previous negatively geared example, if John purchased this type of property then he’d instantly add to his bottom line. That is, he’d have more money from investing in property from day one (before any capital gains) not less.

And under both models he would profit from any capital gains although it has been traditionally claimed that it is difficult to get both capital gains and positive cashflow from the same property.

The bottom line here is that it’s not possible to use negative gearing to consistently invest in property in a way that sees you pocket more cash AND claim also claim a tax deduction at the same time.

How many properties can you afford to own?

Statistics show that only 1 in 200 property investors own more than 5 properties. But if owning property was such a great idea then wouldn’t it make sense to own multiple properties… say 10, 20, 30 or even more?

The reason why only 8% of all investors are able to own 3 or more properties is because of an affordability issue.

Let’s go back to our earlier example and imagine that John was able to buy 5 of the same negatively geared type properties. How would his after-tax financial circumstance look then?

Rental income
$65,000

Rental Management
($5,240)

Loan Interest
($69,345)

Rates etc.
($10,000)

Total
($19,585)

John with
one property

John with
five properties

Salary
$80,000
$80,000

Property tax loss
($3,909)
($19,545)

Taxable income
$76,091
$60,455

Tax + Medicare
($23,711)
($16,230)

Nett income
$52,380
$44,185

What we can see now is that as John owns more properties his after-tax cash position is dramatically shrinking. Sooner or later John will reach the point when he can no longer afford to buy more property. His real after-tax wealth is reducing in ever decreasing circles, which is illustrated in the graph below.

graph

The graph above shows that as John owns more property his after tax available cash decreases, while his losses from owning property increases. This illustrates the decrease in his purchasing power as only a maximum of 48.5% of the property loss can be claimed as a tax deduction. The remainder must be paid out of John’s after-tax salary.

The lack of sustainability is a phenomenon of negative cashflow that is rarely discussed.

The outcome of this investment is that you need to keep working in order to continue to earn enough of a salary to fund the cash drain of the loss making investment.

Five years on…

Let’s take our example of John a few steps further and fast forward five years. His property has appreciated by 40% and is now worth $322,000.

His rent has increased by 10% and he now earns $275 per week, but his rental guarantee has now lapsed and he needs to allow for $1,000 per annum in maintenance. Rates have risen to $2,200. Let’s imagine interest rates have remained steady at 6.7%. During the same time John’s salary has risen to $90,000.

His annual property income statement would now look like:

Rental income
$14,300

Rental Management
($1,144)

Loan Interest
($13,869)

Rates etc.
($2,200)

Maintenance
($1,000)

Total
($3,913)

Based on these figures John’s property has been able to hold it’s own in terms of profitability in that his rental increase has offset his additional expenses. Really though, allowing for inflation, he is slightly worse off as a dollar five years on buys less than a dollar at the time John bought his property.

John with
no property

John with
one property

Salary
$90,000
$90,000

Property tax loss

($3,913)

Taxable income
$90,000
$86,087

Tax + Medicare
($30,457)
($28,559)

Nett income
$59,543
$57,528

Whereas five years ago John was $2,013 out of pocket, now he’s $2,015(58,970 – 56,955) a minuscule deterioration.

But he has earned unrealised capital gains of $92,000.

In summary on paper he’s doing well, but in reality his purchasing power has taken a hit. Negative gearing has achieved an outcome of theoretical wealth-creation but an actual real loss in purchasing power.

Using the equity

But John has made a paper gain of $92,000. If he decided to realise that gain, what options does he have?

  1. Sell

    Assuming John sold his property for $322,000 on the last day of the tax year then his profit would be:

    John with
    no property

    Sales price
    $322,000

    Agent’s commission (4%)
    ($12,880)

    Legals etc.
    ($2,000)

    $307,120

    Acquisition Cost
    ($230,000)

    Gross Capital gain
    $77,120

    50% Exemption (Note 1)
    ($38,560)

    Taxable portion
    $38,560

    Income Tax at 48.5%
    ($18,702)

    After Tax Profit
    $19,858

    Add Tax Free Portion
    $38,560

    Total After Tax Gain
    $58,418

    True After Tax Gain

    Total Gain
    $58,418

    Five Years (After Tax)
    Negative Cashflow
    ($10,065)

    Nett Gain
    $48,353

    My point here is that John’s paper gain of $92,000 is quickly eroded back to $48,353 after adjusting for tax and the negative cashflow. Perhaps it’s pertinent to remember that tax is only payable if you sell, in which case the impact on your net profit can be significant.

    If John sold his property under this circumstance then he would have made a decent return, albeit he would have had to take a lifestyle cut in order to fund the annual negative cashflow from expenses being higher than income.

  2. Hold and refinance

    If John didn’t want to pay tax then he needn’t sell. He could approach his original financier and seek to refinance his loan to 90% of the new value. That is, he could access a further $82,800 (90% ($322,000-$230,000)).

    Should John use this money for investing in other property investments then he would qualify for a tax deduction on the additional interest. But if he did this then his annual negative cashflow would increase because he has borrowed more money.

    It would now appear as:

    Rental income
    $14,300

    Rental Management
    ($1,144)

    Loan Interest (90% of $322k)
    ($19,417)

    Rates etc.
    ($2,200)

    Maintenance
    ($1,000)

    Total
    ($9,461)

    What John would find is that refinancing would allow him to acquire another property with no money down, but the additional interest cost would further reduce his after-tax available cash.

    But the worst thing that John could do is redraw the equity and then fund his lifestyle with the proceeds. If he does this then he will lose the interest deductibility of the redrawn amount – which will have a nasty impact on his overall wealth creation.

    Let’s look at what would happen if John redrew all of his equity and funded a round-the-world extravaganza.

    Rental Income Statement If John
    Refinances And Spends Money On Lifestyle

    Rental income
    $14,300

    Rental Management
    ($1,144)

    Loan Interest (Note 1)
    ($13,869)

    Rates etc.
    ($2,200)

    Maintenance
    ($1,000)

    Total
    ($3,913)

    John with
    one property

    Salary
    $90,000

    Property tax loss
    ($3,913)

    Taxable income
    $86,087

    Income Tax + Medicare
    ($28,559)

    Subtotal
    $57,528

    Non deductible interest
    ($5,548)

    Nett Cashflow
    $51,980

    Note: The total interest would be ($322,000*90%) * 6.7% = $19,417, however on the portion relating to the property investment ($13,869) would be deductible. The remainder ($5,548) is not deductible as it relates to private rather than investment expenditure.

The wash up of all this is that if John sold then he would pocket a handsome gain – the product of steady capital appreciation while he owned the property.

But if he refinanced and then invested the proceeds then his borrowings would increase, as would his interest costs, which would have the effect of further decreasing his nett after-tax available cash.

Even worse, if John refinanced the property and then took his equity and spent it he would be left with an interest bill that was not deductible. He might just as well have applied for a personal loan. Investors should never drawdown on equity to fund a lifestyle. It would be better for John to sell and pay for his trip as at least he would have borrowed the money but would have used realised profits.

Fairytale assumptions

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.

If John had’ve purchased five properties and interest rates rose from 6.7% to 10% then the result would have been disastrous. His after-tax remaining cashflow would be:

Rental Income Statement: John With 5 Properties And Interest Rates Rise to 10%

Rental income
$65,000

Rental Management
($5,240)

Loan Interest
($103,500)

Rates etc.
($10,000)

Total
($53,740)

John with
5 property

Salary
$90,000

Property tax loss
($53,740)

Taxable income
$36,260

Tax + Medicare
($7,594)

Nett income
$28,666

Ouch! John’s available cash has just about been crunched. It’s no wonder so many property developers went to the wall when interest rates spiked at 17% in the early 1990’s.

Assuming that interest rates will remain low or that property prices will rise forever is nothing more than a fairytale assumption that is really the best case scenario.


Please refer to http://www.propertyinvesting.com/strategies/negativegearing.html for more detailed reference on this material

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