Following Labor’s failure to win the election and implement changes to negative gearing, the Coalitions stance on negative gearing looks set to remain as a tax-effective strategy ... at least for the moment anyway!
So, let’s take a moment to reconsider negative gearing and how it can help.
Gearing is the process of borrowing money to purchase an investment, in this case property. When a property is negatively geared, it means that the costs (interest and other costs) are higher than the rental income received for the property, creating a net rental property loss.
This loss reduces the property investors taxable income and creates tax savings for the investor.
The property investor is willing to carry the loss on the expectation that the long-term capital growth of the property will exceed short-term losses.
An example of negative gearing in property would be as follows:
Richard has purchased a property for $500,000 and taken out a mortgage of $400,000. The interest of 5% each year is $20,000 and the weekly rent is $350 per week or $18,200 per year.
Ongoing costs (council rates, water rates, maintenance, etc.) for the property are $4,000 per year and Richard has a quantity surveyor report that allows him to claim depreciation of $2,000 per year.
This tax saving means that Richard’s real loss is only $4,134 ($7,800 – $3,666).
As mentioned, Richard is willing to accept this loss in income because he expects to sell the property in the future at a gain and this (capital) gain will compensate him for the cash invested (the rental losses) in the property over the ownership period.
It is important to note that depreciation, whilst adding to the rental loss, has no cash outlay.
Richard would also benefit when it comes time to sell the property as for an individual investor, only half of the capital gain is taxed (provided the property has been held for over 12 months).
If Richard sold his investment property after 10 years for $750,000 his wealth generation would look something like this:
Market Appreciation $250,000
Less: Capital Gains Tax on Disposal* $(58,750)
Total Capital Return Over 10 Years $191,250
The capital gain has been sufficient to compensate Richard for the loss in rental income.
The strategy does have risks so careful research needs to be undertaken to ensure that the property purchased can appreciate in value over time.
There are many factors to consider including how loans are structured (principle and interest or interest only), interest rates, the level of rental losses and your ability to utilise the loss.
With careful planning, research and the right advice, negative gearing can help minimise taxation and create wealth for investors.