Ever wondered why Australians love investing in property so much? Is it the security of holding a tangible asset or the belief that the property will grow in worth?
Many people also consider property investment to be lucrative due to the ability to offset the cost of owning the property against other taxable income. In fact, if numbers are to be believed, most investors claiming tax deductions fall below the $80,000 income bracket.
According to the tax statistics revealed by the ATO for the year 2012-13, taxpayers claimed a total of $12 billion tax losses from investment properties, and almost 1.3 million taxpayers had negatively geared property. The low interest rates have led to the numbers falling from $13.8 billion in the year 2011-12 to $12 billion tax losses claimed in the year 2012-13.
With Deloitte’s recent report, Mythbusting Tax Reform, bringing the spotlight on negative gearing once again, let’s understand what the fuss is all about.
What is negative gearing?
If you own an investment property and your loan costs are more than the rental income of the property, the taxation department allows you to offset your losses against other assessable income. The concept of deducting legitimate costs of earning an income is an established principle of taxation law.
Contrary to popular opinion, negative gearing is not an investment strategy even though it encourages many people to borrow and invest in a property.
As soon as the rental income of your property increases the costs, the property becomes positively geared and no more tax concessions are applicable. Of course, a savvy investor would any day prefer a positively geared property to tax concessions on a low rent yielding property.
How does negative gearing actually work?
Owning an investment property has costs associated with it. Cash costs in the form of interest payments, insurance premiums and maintenance costs and non-cash costs in the form of depreciation costs.
If you add both these costs and they exceed the rental income, then you can claim the net loss against your other taxable income.
It is possible to maintain a positive cash flow for a negatively geared property by taking advantage of the depreciation benefits. Tax deductions for depreciation coupled with deductions for rental loss on the property can actually yield you a return.
Depreciation refers to the decline in the value of a building over time. An investor is allowed to claim tax deductions for depreciation. The rate can vary between 2.5% to 4% on capital works depending on the age and value of the building.
Don’t forget to get a depreciation schedule made by a property surveyor to max your depreciation benefit.
A case study: Negative gearing example
Having paid off the loan on their home, Samantha and Chris decide to buy an investment property. Having done thorough research, they decide to build a three-bedroom house in suburban Sydney, which they plan to rent out.
With assistance from mortgage brokers at HashChing, they borrow $640,000 (90% of the total purchase price of the house) at a variable rate of 5% for 20 years. Thus, the annual interest payable on the loan is $32,000.
Luckily, they find a tenant as soon as the house is ready and receive an annual rental income of $28,000. They calculate that the costs of maintaining the property and depreciation costs come to approximately $10,000 per year.
Based on the above, they are paying $32,000 as interest per annum and spending $10,000 in costs, but only receiving a yearly rental of $28,000. This means that the property is negatively geared and they can claim a deduction of $14,000 against other taxable income.
Should I invest solely for tax saving?
Negative gearing can be good or bad depending on your investment strategy. If you do not have much saved in the way of deposits, it is possible to borrow most of the purchase price to negatively gear a property and use rentals to pay off most of the interest and other costs.
However, negative gearing should not be an investment strategy but a means to an end. Investing in a property to save tax is not a good idea unless it also gives you a return. You must research and invest in an area of likely capital growth. If your rental income is not enough to pay off the loan, there is no promise that your land will show significant capital growth as well, turning it into a bad investment.
Keep in mind:
- Interest on an investment loan is fully deductible for an income producing property, provided the rental income is less than the total costs.
- Cost of ongoing repairs and maintenance work to keep the property fit for rental is fully deductible.
- Depreciation deductions are allowed on fittings as fixtures as plants. Depreciation at a rate of 2.5% to 4% can be claimed for capital works (undertaken after the year 1987), calculated on the basis of the initial cost.
- Holding the asset for more than 12 months can get you 50% rebate on capital gains tax.
- Lastly, though it goes without saying, you must have an alternate source of income apart from your negatively geared property to actually claim the tax benefit.