Monday 12 October 2015

NEGATIVE GEARING

“I pay too much tax, I need more deductions”

“I need a negatively geared property to reduce my tax”.


Two common sayings I often hear in relation to negative gearing - do they make sense though?
Surprisingly, many people do not quite understand how negative gearing work – but think they do.


WHAT IS NEGATIVE GEARING?


Negative gearing (in relation to property specifically) is when the rental income earned is less than the allowable tax deductions associated with the property.
For example:

  • Rental Income: 24,000
  • Interest: (20,000)
  • Land Tax: (6,000)
  • Other Costs: (8,000)
  • LOSS: (10,000)
The above property is negatively geared to the tune of $10,000 per annum.

COMMON MISCONCEPTION: YOU GET BACK $10,000 FROM THE ATO


Unfortunately not. The loss of $10,000 sits in your income tax return and reduces your taxable income. If you have income from other sources, you will save tax at your marginal tax rate. For example if you have a salary of $100,000 your marginal tax rate will be 39% including Medicare Levy; in this case you will receive a tax refund of $3,900.

ANOTHER COMMON MISCONCEPTION: NEGATIVE GEARING MAKES YOU MONEY


This one needs some further explanation.

In the example above, you have LOST $6,100 in year one (after receiving back your ATO refund). This is what it has cost you to hold the property. If you didn’t hold the property, you would theoretically still have that $6,100 sitting in your bank account (perhaps even earning you a little bit of interest!).

The second year may be similar, as will the third, fourth etc. You are literally losing money every year….

  • Year 1: ($6,100) loss
  • Year 2: ($6,100) loss
  • Year 3: ($6,100) loss
  • Year 4: ($6,100) loss
  • Year 5: ($6,100) loss

TOTAL LOSSES OVER FIVE YEARS = $30,500


So why would you want to hold an asset that loses you money every single year???


CAPITAL GROWTH!
The ONLY reason you would want to hold this asset would be if the VALUE of the property was increasing enough over time to cover your losses. 

If the property above was purchased for $400,000 and sold after 5 years for $440,000 on face value you “made” $40,000, hooray!
However, once you take into account the money you have lost each year on the negative gearing, agent fees and potentially capital gains tax on the sale you may really have not made much more than a very basic rate of return. And don’t forget inflation!

SO IS NEGATIVE GEARING RUBBISH??


Certainly not!

Negative gearing is a concept that has been used by some to greatly enhance their wealth position and property portfolio. If the circumstances are right, it can be a brilliant tool to assist you in growing your net asset position.

You just need to understand how it works, have good real estate agents to provide you with quality advice surrounding properties (in particular their growth prospects and ways to enhance rental yield) and a good accountant to assist you with the taxation side of things.

Good luck and happy investing.