What you need to know about negative gearing

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What you need to know about negative gearing

What is negative gearing in Australia and what are the benefits and downsides? Read on for eChoice’s ultimate guide to negative gearing.

What is negative gearing?

In order to wrap our heads around negative gearing’s meaning, we must first understand the concept of gearing. While this is most commonly spoken about in terms of investment properties, it simply means when you borrow money to invest.

If property is positively geared, the rent you are receiving from your tenants is higher than your expenses (for example, loan repayments and outgoings).

If your property is negatively geared, the rental return is less than how much you are paying to own that property.  Therefore, it creates a deficit you would need to make up with income from your salary, self-employed income or investments.

How negative gearing works

So, why would you want to lose money on a property you own? Well, the idea is that the loss can be offset against your income, therefore reducing your taxable income.

According to Australian tax law, you may be able to claim the interest portion of your loan repayments as well as some other costs, so long as the property can be rented. In order to claim negative gearing, you are required to show the total net rental property loss at label IT6 on your tax return. The amount of the loss is included in your adjusted taxable income and may be used in calculating tax offsets, obligations and concessions.

These losses are deductible in the financial year in which they occurred, giving an immediate benefit to property owners. They can also claim capital items that are subject to depreciation over a longer period of time, as well as depreciation of capital works for building and landscaping, with a rate of 2.5% over 40 years.

Another benefit of negative gearing your property is potential long-term capital growth, with the idea that the property will exponentially increase in value over time and they will make their money back.

What are the downsides?

As with any investment strategy, negative gearing is not without its risks. Firstly, negative gearing can adversely impact your cash flow. As you will be paying money out of your own pocket every month, negative gearing can make it difficult to keep up with bills and debts if you don’t have a surplus of income. It also makes it far more difficult to create an additional passive income or invest in multiple properties.

Another risk of negative gearing is the reliance on capital gains. You’re essentially at the whim of market fluctuations and if property prices go down, you may not ever gain your money back. This is of particular concern in the current real estate landscape, with property prices continuing to fall. Some people also argue that negative gearing makes it more difficult for first-time buyers to break into the property market, as they are forced to compete with seasoned investors.

On the other hand, positively gearing your property means you can consistently make income from rental returns each month, no matter what is happening in the market. It can also greatly improve your buying power and improve your chances of securing other loans, due to the positive cashflow boosting your income.

ASIC’s MoneySmart website gives these positive and negative gearing examples.

“Rod and Karen are brother and sister and both earn around $70,000 per year. They are both thinking about buying an investment property worth $400,000. Interest on an investment loan will be 6% pa, payable on an interest-only basis. Additional property expenses are estimated at $5,000 a year. Rental income is expected to be $500 a week.

Rod will need to borrow the $400,000 needed to buy his investment apartment as he has no savings. Interest on the loan is $2,000 a month, which is tax deductible.

Karen has some money saved so she only needs to borrow $100,000 for a similar apartment. Karen’s interest payment is $500 a month, which is also tax deductible.

Assumptions:

• Tax + Medicare levy includes the low and middle income tax offset.
• Example reflects the interest payable in the first year. Over time this will decrease but so will the tax benefits.
• It does not take into account inflation, increases in rental income or changes to interest rates or income tax rates over time.
• Capital growth is not taken into account as it does not affect income calculations. The same capital gain would be applicable under either scenario.

Karen is positively geared, so her income is considerably higher than Rod’s. If Karen had left her money in a savings account earning 5% interest, her after-tax income would be the same, however, a savings account has no potential for capital gain.

Rod actually has less money in his pocket as most of his rental income is being paid to the bank in interest so he has to cover some of his investment expenses from employment income. He will be hoping a future capital gain will recoup his short-term income losses.”

Negative gearing in Australia

Australia has a complex and chequered history with negative gearing. Technically, Australians have always been able to negatively gear their properties, but there were restrictions on offsetting through income through labour.

In 1985, Bob Hawke’s Australian Labor Party changed the rules on negative gearing, removing these restrictions and allowing offsets on wage income. However, six months later following a tax summit, this was reversed and negative gearing could again only be claimed from rental income. Later that year, the capital gains tax was introduced and the property industry began lobbying to lift the restrictions, claiming that rental investments had taken a hit. In July 1987, the Federal Labor government with Paul Keating as its Treasurer reversed its decision once more, allowing negative gearing losses to be applied against income from labour.

The Henry Tax Review

In 2010, negative gearing came under fire yet again, when the Henry Tax Review was released.

Commissioned by the Rudd Government, the review was intended to guide tax system reforms over the next few decades. Data from this report suggested that wealthy property investors were benefiting from tax concessions, largely paid for by ordinary taxpayers.

The review recommended that the CGT discount be replaced by ‘savings income discount’ covering bank interest, net residential income (including related interest expenses), capital gains and interest expenses related to listed shares. Under this reform, property investors would have been limited to claiming 60% of net income from property investments, as opposed to 100% previously.

However, at the time, Federal Treasurer Wayne Swan immediately ruled out reforms to CGT and negative gearing on the basis it would negatively affect rental supply and affordability.

The Government’s negative gearing policy

Scott Morrison estimates two-thirds of the 1.3 million Australians who currently use negative gearing for investment homes have a taxable annual income of less than $80,000.

His government argues that negative gearing reforms would hurt mum and dad investors, meaning small-scale, non-professional property investors. They also predict that without the incentive of negative gearing, investors will be less likely to buy investment rental properties. They argue that this will result in less rental properties and therefore, owners will drive up rent.

So, with the Coalition’s negative gearing policy set to stay exactly the same, what are they doing to level the playing field in the property market?

The Liberal party proposes that their salary sacrificing First Home Super Savers Accounts will help home buyers save at least 30% faster by salary sacrificing up to $30,000 per person for a home deposit.

They will also allow older Australians (over the age of 65) who are looking to downsize to make non-concessional contributions of up to $300,000 into their super fund from the proceeds of selling their principal home.

Wondering if negative gearing is an option for your property? With changes afoot, now is the time to see if it’s right for you. Speak to one of eChoice’s experienced home loan experts for tailored advice.

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