Getting your strategy right – 1. Negative Gearing

In our last Everyday Property Foundations series post we talked about knowing your endgame. So I’m going to assume at this point that you’ve considered your overall goal – including the amount of money you’re going to require and the timeframe in which you intend to achieve your goals.

In the ‘Getting your strategy right’ section of the foundation series we’re going to introduce a number of ways or strategies that you may want to consider for investing in property. Today’s post is about negative gearing – and that’s because for the majority of investors their investment property will be negatively geared. So let’s look at what negative gearing is and the pros and cons of negative gearing.

What is Negative Gearing

The Australian Tax Office (ATO) says:
“A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.”  (ATO Website, Accessed 9th July, 2012).

The ATO also tells us that your may be able to claim a deduction for the resulting loss from the property against your rental and other income.

So basically, it comes to down to this:

  • You buy a property
  • The expenses from the property exceed the income from the property
  • You are making a loss
  • This loss can be used to offset other taxable income, such as that from your wages/salary as well as your rental income

The Advantages of Negative Gearing

On the ‘pros’ side, negative gearing is good because it helps you to reduce your taxable income, which means you pay less tax.  Many high income earners use negative gearing for this purpose.  Also, property values often (not always) rise over time and this capital growth in the property can be more than the losses and inflation so you may end up in front in the long run.

 

The Disadvantages of Negative Gearing

On the ‘cons’ side of the equation, however, you need to remember that if your property is negatively geared then you are making a loss, which means money is coming out of your pocket each month to pay for the property.  Depending on your circumstances this may impact upon your lifestyle as you will need to use your funds to service the loan and expenses.  When a property runs at a loss this also means there is only so much ‘extra’ income that you have available and so at some point, you will be limited in your ability to buy more properties.

Why would you use negative gearing?

Now many people would think – why would you buy property that makes a loss?  Why would you use negative gearing?  For a lot of people, they just can’t get past the idea of buying something that makes a loss – on purpose – and so they focus on property that is positively geared or has positive cashflow (we’ll cover those in the next article).

The main rationale is that the capital growth in the property you purchase may well outweigh the losses plus inflation over time and all the while you are reducing amount of tax you pay.

Summary

Negative gearing is where the expenses related to your rental property exceed the income and you have a loss where you may be able to claim a tax deduction.

Pro

  • Reduction in overall tax paid

Cons

  • The property is incurring a loss that you must fund out of your own pocket
  • May impact upon your lifestyle
  • Can only buy so many of these before you can no longer afford to buy further properties

What do I think?

If you are going to have a negatively geared property then it should be for the right reasons and simply to reduce tax is not the right reason.

Make sure you do your research to ensure the property you are selecting is in the right location and offers the factors that you believe will provide significant capital growth over time.  This is the right reason, the tax reduction is just a by-product.

Also, look at ways to improve the cashflow of your property, for example, undertaking a renovation to increase the yield of the property as well as increase depreciation benefits.

Comments

  1. Julio Martirena says:

    Hi Kaz,

    just thought I’d share an experiance with fixed loans and offset accounts. I was advised that my offset would still be effective after fixing my entire (100% amount) home loan. Unfortunately, I did not know that the offset would only work on 1% of my entire loan and not the full amount!!! not happy. Anyway, I have some people looking into wether or not I can break out of it now, but this was fixed back in Feb 2012 so I don’t like my chances.

    Just thought I’d share that little bit of information, as the staff that handled my request to fix my interest did not advise me of the 1% rule. Hence would be good to advise everyone else wanting to fix a loan with an offset facility…mind you all banks may vary on this one, but this is with the Dragon St George.

    Great podcasts, keep hem coming….more of Jane Slack-Smith would be good. I’m getting through her new book now.

    regards
    Julio

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