What is negative gearing?
Negative gearing. It’s a term you’ve probably heard before, but what exactly is it? Does it only relate to investment properties or can it be achieved with other investment types? More importantly, is it something you can benefit from?
Have you tuned in to our podcast? Episode 7 is a special Tax Bite Edition of the ‘Small Business All Figured Out’ podcast where our Registered Tax Agents Corinne and Sheryl explain what is negative gearing and how it affects your tax return.
To listen, click play below:
The term ‘gearing’, in a financial sense, simply means borrowing a sum of money to purchase an asset – in this case, we’re talking about the purchase of an investment property.
In the context of investment properties, It’s important that you understand the differences between a negative, neutral or positive geared property before you purchase and finance your investment property.
Negative gearing occurs when the total annual tax deductible expenses incurred on your investment property are more than the total annual rental income received. This results in a loss. Under current Australian tax laws, you can offset the loss against other income or profits you’ve made in a given financial year.
Can assets other than investment properties be negatively geared?
Yes. Negative gearing is a tax planning strategy that can be applied to a range of assets. It’s not just restricted to property investment. For example, you can negatively gear a share portfolio. While many taxpayers choose to negatively gear share investments, residential property remains the asset type that’s most commonly negatively geared by Australians.
What is Positive Gearing?
As soon as the rental income covers the outgoings on an investment property, including interest on your investment loan, it becomes a positively geared property.
A positively geared investment property generates a profit which is treated as income in your tax return. Some taxpayers purposely invest in property that’s positively geared, as they consider it better to make profit on their investment. They understand that they’ll pay tax on that profit – rather than make a loss and receive an increased tax refund or a reduced tax liability.
A positively geared property is more likely to be cash flow positive, and if it’s a property experiencing capital growth then it’s giving you a certain yield/return on investment.
What is Neutral Gearing?
Now that we’ve explained what negative and positive gearing is, it follows that neutral gearing occurs where your rental income covers the expenses, or outgoings, of the property. In other words, you ‘break even’.
In this instance you’re not making a profit that’s taxable, nor are you making a loss that is tax deductible in your rental property tax return.
Is neutral gearing an ideal scenario? It really depends on the ultimate capital growth of the investment property. In the absence of any capital growth, arguably, you may not have lost money whilst holding the property, but could you have achieved a greater return on your capital had it been invested elsewhere? It’s food for thought.
When is negative gearing beneficial?
Negative gearing is beneficial only when the total return on the investment – the capital growth and the yield – is greater than the total costs of holding the property.
How can you estimate the capital growth and yield? Well, the truth is it’s difficult. You’ll need to do some research. Like any prediction of the future, there’s no way of knowing for certain what will happen – and to be honest, it is a bit of a gamble.
You can look at past performance as a guide and recent trends in certain areas for certain property; but ensure that your sources of information are credible as there is a lot of biased information published about property investment. You’ll be better served undertaking your own independent research and discussing your findings with an independent advisor, such as accountants who are experienced with investment properties.
Why do property investors seek negatively geared properties?
Negative gearing is a popular strategy because the tax losses that arise can usually reduce an investor’s other taxable income, resulting in a lower annual income tax bill (or an increased tax refund).
A portion of the tax savings generated can be diverted to fund the investment property. In other words, the tax saved by negative gearing will contribute towards, but ordinarily will not exceed, investment expenses.
Basically this means that there are some slight tax advantages to ‘losing money’. It’s really important to understand though, that you do not receive a tax refund equal to the rental loss that you incur. This can often come as a surprise to some taxpayers who aren’t clear on how the tax law, and the tax return, works.
What actually happens is the tax withheld on your wage and salary income, is reduced by an amount equal to your effective marginal tax rate, multiplied by the excess of deductible expenses over investment income – that is, the tax loss on your property. A simpler way of thinking about it is the tax loss incurred on an investment property has the same effect on your refund as any other tax deductible expense included in your tax return.
Is it better to negatively or positively gear a property?
The answer to this question really depends on a number of factors and is largely dependent on your personal circumstances and personal preferences:
- For negative gearing to financially benefit you, in the long term, you must be investing in property in a time of rising house prices and good capital growth. During a time of global economic uncertainty, betting on capital gains from property can be risky.
- Negative gearing is better suited to taxpayers earning incomes in the higher income tax brackets. The reason being is that these brackets give the biggest tax breaks. In lower tax brackets the benefits of negative gearing are considerably reduced.
- The strategy of negative gearing to acquire property relies on the tax law staying as it is.
Investment properties and tax depreciation
Depreciation, in the context of an investment property, is a non-cash expense that you can deduct as an expense in your tax return. It’s a non-cash expense because, unlike council rates, building insurance and interest on your investment property loan, you’re not having to physically make a cash payment to benefit from the depreciation expense. and, ideally, what you’re aiming for is to have the non-cash depreciation expense cause your property to be negatively geared.
When it comes to investment property, in terms of negative gearing and tax effectiveness, many investors aim to have a negatively geared property for tax purposes, but cash-flow positive property in reality. How is this position achieved? By taking full advantage of the tax-deductible depreciation allowances permitted under the current Australian tax laws.
This means investors are purchasing properties where the rental income is covering the cash outgoings of the property, such as council rates, insurance, mortgage interest etc and the depreciation expense (a non-cash deduction) will act to create the loss in their tax return.
It’s important to note that, in light of some changes to property tax depreciation laws in recent years, your eligibility to claim depreciation will depend on the characteristics of the property you have purchased or are intending to purchase.
If you’re unsure of how depreciation might work for your investment property we recommend that you speak with us; we’re accountants in Melbourne who are investment property experts.
How is investment property depreciation calculated?
The allowable tax deductions for depreciation are calculated out by a licensed quantity surveyor. The licensed quantity surveyor’s job is to estimate the costs of construction and supply you with a report that details the depreciation figures spanning the depreciable life of the property.
Be careful which quantity surveyor you choose to prepare your depreciation report. In our years of experience as Accountants in Melton we’ve found that some quantity surveyors are more thorough than others; and this is important because the goal of rental property tax depreciation is to ensure you’re maximising your tax savings. If you’d like our recommendation for a great quantity surveyor, you’re welcome to get in touch with us.
Remember, negative gearing can turn positive
It’s important to know that your property likely won’t remain negatively geared forever.
At some point the rental income received is going to exceed the expenses you incur on the property, particularly where your interest expense reduces as you pay down the principal loan balance, and also when depreciation reduces – or ends altogether. This will result in the investment property generating a profit which is treated as assessable income in your rental property tax return.
Is it possible to access the cash flow benefits of negative gearing during the year, instead of waiting until tax time?
Yes, in some circumstances, it might be possible and appropriate for a taxpayer to access the cash flow benefits of their negatively geared property investment during the year, rather than having to wait until after 30 June when they’d ordinarily be able to lodge their individual tax return. To do this, you need to apply for an Income Tax Variation with the ATO.
An Income Tax Variation legally instructs your employer to reduce the amount of tax withheld from your wage and salary income. This results in an increased take home (net) pay, which means you’re effectively accessing the cash flow benefits of your negatively geared property throughout the financial year. This means your tax refund may be negligible, because any excess tax refund has been paid to you during the financial year by way of an increased ‘take home’ pay.
Which rental property expenses are tax deductible?
We prepare rental property tax returns for hundreds of property investors, and this is by far the most common question we are asked. Not all expenses that you incur in holding and maintaining your investment property are tax deductible in your tax return. However, we recommend that you keep all receipts and documents to substantiate your rental property expenses, and download our Rental Property Tax Return Checklist for further guidance.
If you’re looking for a tax agent in Melton to help you with your 2020 rental property tax return join our email list to get our best tax tips – no clutter, just the useful stuff.