Negative Gearing in Property Investment: A Comprehensive Guide
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What is Negative Gearing?
Negative Gearing is a strategy property investors use where they borrow money to purchase an investment property and the rental income from the property does not cover the ongoing interest and other costs. You, therefore, run an investment at a cash flow loss where you need to inject money to help cover all the ongoing costs.
The Advantages of Negative Gearing
Negative Gearing has a twofold advantage:
- Any cashflow losses you experience in the short term will be a personal tax deduction against your income.
- As your property grows in value (historically in Australia every ten years) any losses will be swallowed by capital gains.
This strategy works when your property’s value increases over time. If you choose a property that ticks the boxes in a growth location, its value will grow and capital gains are likely. In Australia, especially in capital cities, investors who take the long-term approach, usually come out ahead.
Costs like mortgage interest, maintenance, agent’s fees, rates, and insurance are examples of ongoing costs incurred on an investment property that you will be able to use as a tax deduction against your personal income.
The benefits of negative gearing are especially advantageous to those with higher personal income tax rates. However, according to figures from the ATO, around 80% of people who claim tax deductions on property earned less than $80,000 per annum.
Negative gearing benefits work best when you invest in brand new property (never lived in) as that has the added benefit of property tax depreciation on the annual wear and tear of a building and its fixtures and fittings for residential properties constructed after 1985.
If you have a depreciation report completed by a Quantity Surveyor, you have an additional yearly tax deduction. Sadly, research suggests that only 20% of investors take full advantage of these benefits.
The tax benefits can span up to forty years but the largest tax benefits occur over the first ten years of ownership on a new property. This can often be in the range of $80,000 – $20,000 a year in tax deductions.
You are now cashflow positive, with more money in your pocket and a large tax refund once your tax return has been lodged. Plus, you have more money compared to all the property holding costs.
A Negative Gearing Example
Who benefits from Negative Gearing? Jayne purchased a brand new townhouse in a growth corridor in Brisbane. She receives $20,000 in rent a year and she has an interest-only mortgage that costs $25,000 per year.
She also has yearly costs like landlord insurance, body corporate fees, and property management fees that add up to $5,000. However, she can use the $10,000 (interest $5K & costs $5K) in total losses to reduce her taxable income. With the first-year depreciation deduction of $12,000, as she purchased a new property, she will now have a total tax deduction of $24,000p.a.
She is comfortable with adding a few hundred dollars per week to cover costs and once her tax return is complete she will end up with a cash refund of around $12,000. Purchasing wisely and looking ahead of time for growth is critical with capital gains, as she works toward her investment doubling in value over time. This is how Negative Gearing works.
Positive vs Negative Gearing
A positively geared property means that the rental income is greater than the interest and ongoing costs. A cashflow-positive property will give you passive income from day one that can help pay off debt like your mortgage or save a deposit to add to your portfolio.
The disadvantages are that you will pay tax on any extra income and capital growth can be slower.
Is Negative Gearing Good or Bad?
Negatives: a negative cash flow restricts an investor’s ability to borrow more funds and grow a portfolio. Positives: an investor will not have an immediate cash flow, but will have immediate tax advantages and a tax refund.
Your capital returns on the property will eventually supersede your costs. Owners with negatively geared properties can often opt to keep their rents slightly lower than market rent, offering more competitive rent that incentivizes tenants to stay long-term.
It is important to do your homework on everything from selecting growth opportunities to property managers and everything in between.
Once you understand how it works, the benefits of a negatively geared property remain: the short-term losses on the property will lower your personal taxable income; with the long-term objective of capital growth for future profit.