Negative Gearing - The Key to Investing in Real Property
When preparing Individual Tax Returns, there are two questions that are on everyone’s minds:
How big is my refund?
What can I do to pay less tax?
One of the most attractive answers to both of these questions is the use of a negatively geared rental property. The biggest drawcard of this arrangement is the ability to apply the loss from the rental property against other income which in most cases will result in a significantly higher refund.
So how do we create a negative gearing arrangement and what are the long term benefits? Negative gearing is the result of the costs outweighing the income for the property. In most cases, this is achieved by the property being mortgaged and the interest costs creating a negative cashflow effect to the deductible costs of the property. In simple terms, the interest incurred on the loan along with the normal ownership costs of the property will in most cases outweigh the income that is being earned from tenants within the property. For an income earner, the resulting loss can then be offset against other income such as employment income resulting in a lower taxable income and maximising income tax refunds.
This arrangement is an attractive tool for those whose other taxable income is over $90,000 as it limits the impact of the higher tax bracket.
On face value both questions are answered so is there any downfall? As in most cases, there are two sides of the coin to consider. The above arrangement provides a favourable tax outcome however creating a loss requires a positive cash flow to service the loss and there could be a tax impact where the property moves from negative gearing to a positive outcome.
A negative gear arrangement will give an encouraging tax outcome however it does rely on the property owner being able to meet not only the overrun on costs but also the principal component of the loan. While the interest portion of the property remains deductible the principle does not. A property owner needs to ensure when they are entering such an arrangement they have sufficient servicing for the capital component of the loan and to provide for paying down of the capital component of the loan.
While negative gearing can be an effective tax planning tool CPI increases in rental income and a decreasing interest component each financial year could result in a profit on the rental property over time. The outcome of a positive position could be an additional income tax liability for the property owner.
For example, a taxpayer with an employment income of $90,000 and a rental profit of $5,000 would incur an additional income tax liability of $1,291.95 being an average rate of tax of 25.83% (including Medicare Levy). A point to remember though is that although a rental profit does incur an additional income tax liability it is only a portion of the profit and the cashflow of the property owner is positively impacted in this scenario by $3,708.05.
In summary, a tax saving can be achieved by a negatively geared arrangement. It does come with a need to have access to a positive cashflow and to have the capacity to absorb the loss as the financial year carries through. At this stage, the question may start to rise in one’s mind: Is there really a benefit to doing this? A Negative cashflow to receive a proportionate tax saving? Am I really making a saving? These are all important questions and they highlight an underlying benefit from a very well planned negative gearing arrangement: Equity Growth.
A property purchased for fair market value in an area with the potential for growth will increase in value over time. While a negative gearing arrangement gives an immediate benefit a property that has the right mix in purchase price and growth will be impassively growing giving a true benefit to the purchaser.
When an investor makes a future decision to dispose of the property, there is great potential for a significant gain to be realised from the growth in investment. This is the point in time that the greater benefit is achieved from a well-planned property acquisition. Although Capital Gains may arise at the time of disposal, the resulting Income tax liability will only be a proportion of the gain and the resulting profit will be a significant equity recoupment for the purchaser.
Developing an effective property arrangement can have significant benefits to a Taxpayer. If you want to explore the process further, contact our office and discuss with our Accountants how such an arrangement can benefit you and the long term financial gains you can achieve.