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Negative gearing is back in the news. A report by the Australian Housing & Urban Research Institute (AHURI) proposes to “eliminate negative gearing deductions for wealthy investors.” According to the report, “$1.7 billion could be saved each year by radical changes to the negative gearing regime.” According to the proposal, lower income investors in the bottom 50 percent would remain unaffected while the high-income investors in the top 25 percent would receive zero deductions. Those in between the two brackets would have their deductions reduced to 50 percent. [Source: ABC.net.au]

 
Positive and negative gearing explained
 

While it is uncertain that the government would accept the proposal, there is no arguing that the ability to offset the costs of owning a property against other taxable income has helped many investors in Australia manage their cash flow better. However, it must be understood that negative gearing is not an investment strategy. Ultimately, an investor aims to earn money, and not offset losses or depend on tax deductions for their cash flow. Thus, a savvy investor would any day prefer a property with a positive cash flow compared to a negatively geared one. Let us understand the difference between the two situations below.


What is negative gearing?

When you borrow money to purchase an investment property and find that your rental income is lesser than the interest you are repaying and other expenses, it means that your property is negatively geared. Fortunately, in Australia, you can offset your losses against other assessable income in the form of tax deductions. Besides, once you receive the tax deductions for negative gearing and property depreciation, you can actually save a significant amount of money.

However, investing in property solely for saving tax is not a great idea. At the end of each year, you must cover the losses yourself, and unless the property increases in value to ultimately cover your loss when you sell it, it does not make sense. Remember, you’d also be paying capital gains tax when you sell the property.

On the other hand, a positively geared property gives you returns from day one that can be used to purchase another investment property or pay off your mortgage faster. The only disadvantage is that you’d be paying more tax on the additional income.


Lisa and John buy rental properties

Lisa is an architect who saved money for several years to buy a rental property. Finally, with $250,000 in her kitty for a deposit, she decided to buy an apartment in a middle-ring suburb that cost her $500,000.

She found tenants for the property quickly and earns $2,500 in rent each month. Her monthly interest and expenses amount to $1,200. Thus, Lisa makes $1,300 from her rental property each month. Her rental yield is 6.24 percent. It can be calculated by dividing her annual rental income ($15,600) by the initial deposit amount of $250,000.

John, Lisa’s friend, also bought an apartment worth $500,000 at the same time as Lisa. However, he only had 20 percent of the purchase price as a deposit. Thus, he had to borrow much more than Lisa did to buy her rental home. John also found tenants for his home soon enough and earns $2,500 in rent each month. However, his mortgage and other expenses amount to $3,000 per month, which means he is incurring a loss of $500 each month or $6,000 each year.

John can, however, offset the loss of $6,000 against his taxable income. Assuming a tax rate of 33 percent, this would help him save around $2,000 on his tax bill. In this example, we can see that John is applying most of his rental income to service his mortgage and other expenses. However, John does not mind spending $4,000 per annum from his pocket on his investment property as he aims to recoup his short-term losses through future capital gain.


Negatively geared or not?

As you can see from Lisa and John’s example, negative gearing can be used efficiently to minimise your tax. However, the real reason why you can reduce your tax is that your overall income is decreased. On the other hand, if you borrow money to invest in a positively geared property, it would be self-funding right from the start. Of course, you’d end up paying more tax, but you’d also be earning more money that can be used to expand your property portfolio further.

Experts suggest that negative gearing should be used as the means to an end. Tax saving should not be the reason for investing in a property. Rather, it is advisable to invest in a property after crunching the numbers and estimating its long-term value so that it does not remain a loss-making investment forever. Read more about negative gearing or discuss your investment strategy in detail with a mortgage broker by posting your query online or filling up this contact form.

If you plan to purchase an investment property, you could benefit from comparing broker pre-negotiated home loan rates here.

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By Vidhu Bajaj,
HashChing Content Writer

 

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