Negative Gearing seems to be all the rage lately. Half the population hates it because they feel it is responsible for the inflated house prices and the other half love it because they’re getting tax breaks to build wealth. However, after talking with many clients, chatting with friends and family and reading online forums, I have picked up that most people don’t actually understand the basics of it and how/why it can be a great strategy for some but a terrible strategy for others.
Explained simply, negative gearing is a way to reduce your taxable income year to year while making a capital gain on your investment over the long term resulting in a long term net gain.
So, how does this work? You buy a property and rent it out. The cost to run the property (including management fees, council rates, depreciation, interest and fees associated with any loan etc) are offset against any income from the property (rent), generally resulting in a loss.
Example: Property A
Expenses: $20,000 per annum
Income: $15,600 per annum
The resulting loss is $4,400 and reduces your taxable income by that amount. For example, if your income was $52,000 per annum, you would pay tax on $47,600 instead. Overall, reducing how much tax you pay by approximately $1,500.
But why on earth would you want to LOSE money just to reduce your tax? The idea being that the property has increased in value over that same 12 months. For the sake of the argument, we will say property value increases 6% per year. That $300k property is now worth $321,000. So while you have made a loss of $4,400 in that year from an income perspective, your asset has increased by $21,000 and you have reduced the tax you paid by $1,500. Do this year on year over the long term and it represents a significant net gain.
What happens when you sell the asset? Well, you pay Capital Gains Tax (CGT). Explained simply, if you bought it for $300k and sell it for $500k, $200k gets added to your taxable income in the year it is sold! BUT under the current government rules, providing you have owned the assets for more than 12 months, you get a 50% discount on that CGT, meaning you only pay tax on $100k instead of $200k.
Sounds pretty appealing doesn’t it? Using basic figures like above over the long term, absolutely! But there are risks and in a market which is deemed to be heavily inflated, these risks can be substantial. The strategy relies heavily on the value of your property increasing, therefore, utilising negative gearing is a long term strategy as housing prices will generally increase over the long term. If implemented over the short term and if housing prices decrease once the strategy is implemented, it can result in a significant loss. This was seen in many mining towns in WA and QLD where some properties dropped upwards of 30% in 12 months.
So is negative gearing right for me? Negative gearing is not just for the rich, though it can provide bigger benefits for those with a higher taxable income. Negative gearing is appropriate for those who have a long investment horizon and are willing to see short term losses and possibly significant risk for long term gain. In a time where housing prices are significantly higher than they’ve ever been (in some states) and a strategy which relies heavily on these housing prices needing to increase further, one needs to ask themselves ‘Is this an appropriate strategy for me?’. If you can’t confidently say ‘I am in this for the long term (7-10+ years)’ and aren’t willing to ride out any short term losses, then perhaps negative gearing isn’t for you.
As always, it is best to speak to a financial adviser or your accountant to decide if this is an appropriate avenue for you. This article was written to explain Negative Gearing in its simplest form and does not comprehensively cover the topic and all its benefits or consequences.
I am happy to provide more detailed information to those who ask, but cannot provide specific advice for your circumstances.
Information current as of 26 June 2017.
This information is of a general nature only and has been prepared without taking into account your particular financial needs, circumstances and objectives. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication.