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What is Negative Gearing?
Negative gearing is a popular investment strategy in Australia, where an investor borrows money to purchase an income-producing property, and the income generated from the property is less than the expenses associated with owning and managing it. As a result, the investor experiences a financial loss, which can be claimed as a tax deduction against their personal income. This strategy aims to provide long-term capital growth through appreciation in the property's value. For more on property investment tax strategies, see our 6 Easy Ways to Minimise Tax and Business structures guides.
Pros and cons of negative gearing
Pros
Tax benefits: The losses incurred through negative gearing can be offset against other income, reducing an investor's taxable income.
Capital growth: Investors can benefit from long-term capital growth as the property's value increases over time.
Cons
Cash flow issues: Negative gearing relies on making a loss, which can create cash flow problems for investors who do not manage their finances effectively.
Market risk: Property prices may not always rise, which can lead to a lower return on investment.
The Mechanics of Negative Gearing
Expenses and Deductions
Investors can claim various deductions related to their negatively geared property, including:
- Interest on the investment loan
- Property management fees
- Repairs and maintenance costs
- Depreciation on the building and fixtures
- Insurance premiums
- Council rates and taxes
Tax Implications
The losses incurred from a negatively geared property can be deducted from an investor's taxable income, reducing the amount of tax payable. This can lead to significant tax savings, especially for those in higher tax brackets. For more on tax deductions and compliance, see our Navigating Work-Related Expenses and ATO Appeals Truck Driver Meal Expense Ruling posts.
Capital Gains Tax
When selling a negatively geared property, investors may be subject to capital gains tax (CGT) on the profit made from the sale. However, if the property is held for over 12 months, the investor can benefit from a 50% discount on the CGT payable. You can use our capital gains tax calculator to work our your capital gains tax. For more on capital gains and superannuation, see our Australian Super Contribution Caps & Tax Explained and Super Contribution Splitting guides.
How to Use Negative Gearing Effectively
Choosing the Right Property
To maximize the benefits of negative gearing, investors should carefully research and select properties with strong growth potential. This may include considering factors such as location, local infrastructure, and demand for rental properties.
Financing and Structuring Your Investment
An effective negative gearing strategy requires careful financial planning and structuring. This includes selecting the right investment loan, managing interest rates, and considering ownership structures such as trusts or self-managed super funds.
Cash Flow Management
Negative gearing relies on making a loss, which can create cash flow challenges for investors. To manage this, it's essential to have a clear understanding of your financial position and create a budget to track expenses and rental income. This will help ensure you can cover the costs associated with your investment property and maintain a healthy cash flow.
Negative Gearing vs. Positive Gearing
The Differences
While negative gearing involves making a loss on your investment property, positive gearing occurs when the rental income generated by the property exceeds the expenses associated with owning and managing it. With positive gearing, investors receive a net profit, which is subject to taxation. You can use the negative gearing calculator to work out the tax impact.
Pros and Cons of Each Strategy
Negative gearing pros and cons:
- Pros: Tax benefits, long-term capital growth potential
- Cons: Cash flow issues, market risk
Positive gearing pros and cons:
- Pros: Immediate cash flow, reduced reliance on capital growth
- Cons: Tax on rental income, potentially lower long-term returns
Changes to Negative Gearing Laws
Recent Legislation
In recent years, there have been discussions around changes to negative gearing laws in Australia. While no significant changes have been implemented, it's essential for investors to stay informed about potential legislative shifts that could impact their investment strategy.
Impact on Investors
Changes to negative gearing laws could affect the tax benefits associated with the strategy, potentially reducing the appeal of negatively geared property investments. Investors should consider diversifying their investment portfolio and exploring alternative strategies to minimize the impact of any legislative changes.
How claiming depreciation and capital works deductions impacts negative gearing property and how it affects the cost base of the property
Claiming depreciation and capital works deductions can have a significant impact on negatively geared properties by reducing the investor's taxable income, and thus, increasing tax savings. These deductions also affect the cost base of the property, which can influence capital gains tax calculations when selling the property.
Depreciation deductions
Depreciation refers to the decline in value of the assets within the property, such as fixtures and fittings (e.g., carpets, blinds, and appliances). Investors can claim depreciation deductions for the wear and tear of these assets over time. Depreciation is a non-cash expense, meaning that it doesn't require an out-of-pocket payment but can still be claimed as a tax deduction, which reduces the investor's taxable income.
In the 2017 budget, changes to depreciation rules were announced that impact property investors. For properties acquired before May 9, 2017, investors can claim depreciation on plant and equipment based on a surveyor's assessment of its remaining life and value. For properties acquired after May 9, 2017, depreciation only applies to plant and equipment that investors paid for or that were included as part of the new property. Subsequent owners cannot claim deductions for plant and equipment purchased by previous owners. This change in entitlement to depreciation affects property investors and their ability to claim deductions.
Capital works deductions
Capital works deductions, also known as building allowance or division 43 deductions, relate to the construction cost of the building and any major renovations or improvements made to the property. Investors can claim capital works deductions over a specified period, usually 40 years, at a rate of 2.5% per annum for residential properties. These deductions help offset the costs associated with maintaining and improving the property and can further reduce the investor's taxable income.
Impact on negative gearing
Claiming depreciation and capital works deductions can enhance the benefits of a negatively geared property by reducing the investor's taxable income even further. This leads to increased tax savings, which can help offset the cash flow issues associated with making a loss on the investment property.
Effect on the cost base of the property
When it comes to calculating the capital gains tax (CGT) on the sale of a property, the cost base plays a crucial role. The cost base includes the original purchase price of the property, acquisition costs, holding costs, and improvement costs.
Claiming depreciation and capital works deductions can affect the cost base of the property, as these deductions reduce the property's original cost for CGT purposes. When you sell the property, you must add back the claimed depreciation deductions to the cost base, effectively increasing the capital gain and, subsequently, the CGT payable. This can significantly impact the investor's return on investment, especially if the property has been held for a long time and has accumulated a significant amount of depreciation deductions.
In conclusion, claiming depreciation and capital works deductions can significantly impact negatively geared properties by reducing the investor's taxable income and increasing tax savings. However, it is essential to be aware of the effect these deductions have on the cost base of the property, as they can influence the CGT calculations when selling the property. It is recommended that investors consult with tax professionals or financial advisors to ensure they are maximizing their tax benefits while complying with tax laws.
How leverage helps in acquiring a property, amplifying returns, and associated risks
Leverage refers to the use of borrowed capital to finance an investment, such as purchasing a property. In real estate, leverage involves using a mortgage or loan to cover a portion of the property's purchase price, with the investor contributing the remaining amount as a down payment. Leverage plays a crucial role in property investments by enabling investors to acquire properties with less personal capital, amplifying returns, and creating potential risks.
Acquiring a property using leverage
Leverage allows investors to purchase properties with a smaller initial capital outlay by borrowing money from a lender. For example, if an investor wants to buy a property worth $500,000 and has $100,000 for a down payment, they can use leverage to acquire the property by borrowing the remaining $400,000 from a lender. This enables the investor to enter the property market and potentially benefit from capital growth and rental income without having to save the entire purchase price upfront.
Amplifying returns through leverage
Leverage can significantly amplify returns on property investments by increasing the investor's exposure to capital growth. As property prices increase over time, the investor's equity in the property also increases, resulting in a higher return on investment (ROI).
For example, let's assume the investor mentioned earlier purchases the $500,000 property using a $100,000 down payment and a $400,000 loan. If the property's value increases by 5% to $525,000 in the first year, the investor's equity has grown by $25,000. This represents a 25% return on the initial $100,000 investment, as opposed to a 5% return without leverage. You can use our calculator to work out you return on equity on property investment
Risks associated with leverage
While leverage can amplify returns, it also comes with potential risks:
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Increased debt: Using leverage increases the investor's debt, which can lead to higher interest costs and monthly repayments. This can put pressure on the investor's cash flow, especially in the case of negatively geared properties.
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Market fluctuations: Leveraging a property investment also means that the investor is more exposed to market fluctuations. If property prices decline, the investor's equity may decrease, leading to a lower ROI or even a negative return.
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Interest rate risk: Borrowing money to finance a property investment exposes the investor to interest rate risk. If interest rates rise, the cost of servicing the debt may increase, making it more challenging to meet loan repayments and negatively impacting cash flow.
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Loss of equity: In extreme cases, if property prices fall significantly and the investor is unable to meet loan repayments, the lender may repossess the property. This can result in the investor losing their initial equity and potentially damaging their credit rating.
In conclusion, leverage can help investors acquire properties with less personal capital and amplify returns through increased exposure to capital growth. However, it also carries potential risks, such as increased debt, market fluctuations, interest rate risk, and loss of equity. Investors should carefully consider their financial situation, risk tolerance, and market conditions before using leverage in property investments.
Conclusion
Negative gearing is a popular investment strategy in Australia, offering tax benefits and long-term capital growth potential. However, it's essential to carefully plan and manage your investment to avoid cash flow issues and maximize returns. By understanding the mechanics of negative gearing, choosing the right property, and staying informed about potential legislative changes, you can make the most of this investment approach.
If you have any questions or would like more information, don't hesitate to book an online appointment or contact us. Our team of experts is here to help.
