Negative gearing is one of those tax concessions most people have heard of.
Pretty much everyone wants to negatively gear, to be seen as a successful property investor.
It’s one of the most commonly asked questions I receive as a tax professional, and it’s no surprise - negative gearing has been hotly promoted and used as a political football for many years now.
Those that understand it can certainly benefit from this tax concession, and those that don’t understand, will lose money without even knowing it.
So what exactly is negative gearing?
Negative gearing refers to the tax policy that allows a loss on an investment to be offset against your other income, which for most people is their salary and wages.
This results in a reduction in your overall taxable income, resulting in you paying less tax.
In Australia, it seems that minimising tax is a national sport, so any form of strategy to legally reduce tax gets a lot of interest. Combined with a love affair with property, and it's not hard to see why this is one of the most loved tax concessions going around.
There are two key components to negative gearing - the 'negative' and 'gearing' parts:
‘Gearing’ refers to utilising a loan to buy an asset. When you borrow to buy an asset, it is effectively referred to as gearing.
The 'negative' part means that the return on the investment is negative - i.e. the money you make from the investment is less than the expenses. This results in a loss on the investment, the loss of which can be used to reduce your taxable income.
Negative gearing can also be used for other investments such as shares and managed funds, but let’s stick to property for an example of how this plays out.
Joe Bloggs buys a rental property in the inner city of Sydney. He pays $1,000,000 for the property. His yearly expenses look something like this:
Rental income | $30,000 |
Less: | |
Property agent fees | $2,400 |
Rates | $1,200 |
Body corporate | $5,000 |
Interest on loan | $40,000 |
Repairs | $800 |
Insurance | $600 |
Annual loss | $20,000 |
That loss of $20,000 can be applied against his other income. The table below shows the savings available for Joe.
Taxable Income | Marginal Tax Rate | Saving on $20,000 loss per year |
$0-$18,200 | 0% | $0 |
$18,200-$37,000 | 21% | $4,200 |
$37,000-$90,000 | 34.5% | $6,900 |
$90,000-$180,000 | 39% | $7,800 |
$180,000 and above | 47% | $9,400 |
I can see why negative gearing is so popular, who wouldn’t want to buy a property investment and get a tax deduction for it?
Another way of looking at negative gearing is that for every dollar the investment costs you, the government helps subsidise this cost by giving you a tax benefit.
Not bad at all.
When does negative gearing work best?
Negative gearing works best when you understand the following - for every dollar you are losing, you need to be at least matching this with the capital growth of your asset.
If you can’t do this, you’ve purchased the worst kind of investment possible - one that costs you money and doesn’t go up in value, and that you had to borrow to be able to afford.
No one wants to be stuck with an investment that isn’t producing a result, with a loan that hangs around forever.
In my experience I have found the following strategies work best when utilising negative gearing:
A high income earner uses negative gearing to reduce their income during their peak earning years. Negative gearing helps reduce their taxable income, increasing their tax refund, and also helps them afford the rental property.
When they retire from work, they decide to sell the property. They sell the property after owning the property for a number of years, entitling them to the 50% Capital Gains Tax discount. Because they sold the property when they were no longer working, they also have less other income, reducing the taxable payable on disposal of the property.
In this example, they have obtained the benefits of negative gearing when they were earning salary and wage income, and delay the Capital Gains event until they were retired, effectively being taxed on the capital growth at a much lower tax rate.
Negative gearing also works when you find your dream retirement house, maybe you can’t afford to live in it just yet, so you decide to rent it out and secure your dream place. When you can afford to move into this place, you make the move. That way you have achieved the benefits of negative gearing, and deferred the Capital Gains Tax until you sell (which may be a very long time away if it’s your dream house).
When does negative gearing fall down?
People tend to forget that when you negatively gear, you are losing money. Yes the government helps you by giving you some tax back, but you’ve still got to fund the overall loss out of your own pocket.
Remember in the example above, even high income earners have to fund $10,600 in losses each year out of their own pocket.
To make the pain point worse, when the 'loss' calculated, it only takes into account your income and expenses, not your loan repayments. This means that the ‘loss’ on negative gearing doesn’t include the principal proportion of your loan repayments, which you also have to fund out of your own pocket too.
Worse still, assets aren't immediately deducted and are instead depreciated over a number of years.
A lot of people just look at the tax refund rather than the overall financial picture.
If you are negatively gearing, beware of the following issues that tend to catch people out:
Buying a negatively geared property in the name of a high income earner, with the intention of using the losses to reduce their income. They instead decide to quickly pay down the loan on the property, making the property positively geared and producing a profit. Instead of saving them tax, because the property is now making money, they end up paying extra tax. Worse still, they later sell the property, paying Capital Gains Tax in the name of a high income earning individual.
People may accidentally pay off their property loan by using inappropriate loan structures. I talk more about this here.
As the loss and principal repayments have to be funded out of your own pocket, make sure you have the cash flow to fund this from other sources. I.e. the property won’t fund itself, so make sure your wage is enough to pay the shortfall.
Ultimately though, the worst thing that can be done is buying a loss making property that doesn’t increase in value.
Look at the history of the property you are buying, and only buy if there is a history of capital growth.
When investing in property, remember this - property is expensive to buy and hold. It is typically low yield, and repairs seem to pop up all the time.
When you negatively gear, you want ensure that your capital growth is at least matching the loss the property is generating each year.
Using the earlier example, let’s consider the capital growth required in order to just break even. In this example, we assume a high income earner, paying tax at 47%.
Here’s an example of how a negatively geared property may play out over 10 years of ownership:
Purchase costs - stamp duty, legal fees | $41,500 |
Annualised after tax loss over 10 year period | $106,000 |
Selling costs (agent fees, legal fees) | $20,000 |
Capital Gains Tax payable | $58,750 |
TOTAL COSTS | $226,250 |
Therefore, Joe Bloggs will need capital growth of $226,250 over 10 years just to break even on this property.
On a purchase price of $1million, this it a 23% capital growth.
Remember this is just to break even - if you want to make money you’ll have to achieve higher capital growth.
Now that you know how negative gearing works, it’s important to have a plan. Model how it will look over time, work out how much it will cost you after-tax, identify the capital growth required to offset these costs, and look at the history of the property to make sure this has been achieved.
Only then are you ready to negatively gear.
In my opinion, negative gearing is far from what it’s cracked up to be. If used effectively, it can be a great way to reduce tax. If used recklessly, it can really cost you in the long-term.
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