We Australians love property, don’t we? But why is this the case?
Well, our Australian history tells us it’s an asset that has always been in demand. It’s physical, easy to understand, it offers proven returns and you can borrow money to buy it.
But all of those things are generally true about real estate in other countries — so, what makes Australia so special?
Two words — negative gearing.
Our Government has created tax savings to purposefully steer investors toward buying homes, with the hope of meeting the housing need brought on by the Government’s need for population growth and the sudden retirement of the Baby Boomer generation.
In most countries, investors are only allowed to deduct losses against the same asset class's income. However, in Australia, the Government allows investors to carry an asset's loss against all of their personal income, which is very generous and typically results in tax savings.
This negative gearing benefit has encouraged real estate investment across the community — from “Mum and Dad” investors to full-time property investors.
The tax savings and the potential for capital growth to grow a retirement nest egg has become a major driver for negative gearing in Australia.
What is negative gearing?
Negative gearing occurs when the deductible expenses — including interest on the loan used to purchase the property — exceeds the property's rental income.
Basically, the property owner is incurring a loss and will have to pay for expenses from their own pocket.
This is vitally important for investors to understand. Should they be unable to gain access to extra cash regularly to cover ongoing expenses, they could be forced to sell the property at a loss.
Is negative gearing risky?
As risky as it sounds, incorporating negative gearing on a property (or multiple properties) as part of your long-term investment strategy is a way of creating property growth and tax savings.
Negative gearing is a strategy that provides immediate tax benefits while also offering the promise of long-term gains in the form of capital housing growth.
Incurring an investment loss means you reduce your taxable income. Therefore, the amount of tax you pay is also reduced, leading to larger refunds. These refunds can then be redirected to reduce your debt quicker, thus building faster equity in your home.
This equity can then be used to purchase and finance more investment properties, therefore building up your dream property portfolio or what financial advisors call "wealth creation.”
If you’re going to invest your hard-earned money, then you need to formulate a plan or, as advisors call it, an “investment strategy." A sound investment strategy should reflect your financial goals, budget, and personal cash flow, which can be used to fund any shortfalls.
A solid investment strategy should also weigh up the risks involved before investing.
As with any investment strategy, negative gearing has specific risks, which include:
1. Cash flow shortages
Any shortfall between the rental income and the loan repayments will need to be budgeted for to ensure you have enough cash left over each month to cover the difference. Failure to keep up with loan repayments and budget for the shortfall could result in your property being taken back by the bank. A monthly cash flow plan is a great way to minimise the risk of any unexpected shortfalls.
2. No tenants
If the property is unoccupied for a long period, this will ultimately lead to a loss of rental income. But on the flip side, this will also increase your annual losses, and you will be able to apply these larger losses against your income. The question is — how long will you be able to absorb this cashflow shortfall? A cash flow forecast can help keep you on track.
When choosing a region or suburb to buy an investment property, it’s essential that investors do their homework, especially for areas that have high vacancy rates.
3. Property value decreases
The reality is that sometimes, despite all your research, there is always a risk that property prices can fall over time.
You can’t completely guard against variations of the property market, but you can reduce the risk by only buying properties in desirable and up-and-coming neighbourhoods. These properties will likely see the least amount of price drop even in bad economic times and will rebound first when prices recover.
Properties that are making a negative gearing loss and are not growing in value greater than this loss are not desirable properties to keep. As an investor, you should consider the pros and cons of selling the property if property values don’t recover.
How does negative gearing work?
Investment property owners can typically claim all property expenses when the property is rented or available for rent.
Available for rent means that the property is advertised either through a real estate agent, Airbnb or private options like Gum Tree.
Immediate deductions can be claimed against expenses related to advertising for tenants, body corporate fees and charges, council rates, water charges, land tax, cleaning, gardening and, lawn mowing, pest control, insurance, property agent's fees and commission, repairs and maintenance and some legal expenses.
To determine the deductible amounts for properties that are: available for rent for only part of the year; not entirely used for rent; rented at non-commercial rates, investors will have to apportion expenses and, in some cases, spread their deductions over multiple years. This is even the case when the property is used for a holiday rental and the property is used by the owner for a period of time during the year. In this case the property total expenses would need to be apportioned over a period of time as well.
Investors are not allowed to claim expenses that they do not directly pay, such as water and electricity charges, which are paid for by tenants. Acquisition and disposal costs, as well as GST credits, are also not considered as deductions that can be claimed.
Is the principal and interest on my negative gearing loan tax deductible?
Unfortunately, the principal portion of the loan repayment is not tax-deductible; however, the interest portion is.
The interest that you pay on your investment loan is 100% tax-deductible. Using the below example of a $600,000 investment property purchase, and if you have a 10% deposit ($60,000), then you will obtain a loan for $540,000. With a 4.1% interest only, loan this is $22,000 (rounded) per year, which is 100% tax-deductible.
Depreciation and negative gearing
An excellent opportunity for investors to strengthen their negative gearing strategy is to use the favourable ATO rules regarding depreciation. Depending on the amount claimed, depreciation can help push your investment property into a negative geared position without having to spend extra cash.
There are two main depreciation methods that can be deducted under Division 40 and 43 of the Income Tax Assessment Act 1936.
- Division 40 allows you to deduct depreciation costs on new interior fittings, including appliances, carpets, curtains and hardwood flooring. From 2018 a property investor who acquires a residential rental property after 7.30pm AEST on 9 May 2017 from a previous owner (‘second-hand property’) will not be entitled to claim Division 40 depreciation from 1 July 2017 for existing depreciable assets in that property. However, any qualifying (i.e. new) depreciable assets acquired for a second-hand property can be depreciated as normal to the extent they are used for income-earning purposes
- Division 43 allows you to deduct construction costs at a rate of 2.5% per year on a new build for 40 years. The constructions costs include the brick and mortar of the house plus any further renovations costs that is considered capital.
Typically, the ATO considers it appropriate to use a quantity surveyor to help assess the depreciation amounts claimed in your tax return. We strongly recommend engaging a quantity surveyor when purchasing a rental property.
Many different companies offer this service. Once engaged, the surveyor will review your investment property costs and provide a schedule of how much depreciation can be claimed each year. The costs of the surveyor (like an accountant) are also tax-deductible.
The great thing about depreciation is that the depreciation you claim is not real money — it's considered a “paper loss." This is great news as it means that you receive a tax deduction amount and have no out-of-pocket cost.
Using depreciation to full effect is a great strategy in maximising deductions and creating a sound negative strategy.
Do I pay tax when I sell my investment property?
Potentially. Capital gains tax is the fee you pay on any profit made from the sale of an investment property.
This profit is referred to as a capital gain and is the difference between what you paid for the property (your cost base) and what you sold it for. It’s included in your assessable income and taxed at your marginal rate.
There are discounts on profits and partial or full exemptions on sale but is dependent on each individual circumstance.
Negative vs positive gearing
Many experienced property investors will say there are only two ways to make money in real estate:
Capital growth: This is when your property increases in value.
- Positive cash flow returns: When the rental income is greater than all of the expenses of holding and renting out a property combined.
The perfect place is when you can get both growth and positive cash flow at the same time, but with negative gearing, you’re restricted to only one way of making money, which is through capital growth.
From our own experience, we find our clients hesitant to invest in a business, shares or managed funds due to the share market's volatility although these investments can be sold more easily than property. Many also don’t understand how the share market works and can’t find a trusted financial advisor to manage their portfolios.
So, property investment properties can be the perfect choice for investors of all types to build an investment portfolio.
However, the difference between a property that makes a profit or is positively geared and a negatively geared property usually comes down to whether the property's loan amount has been repaid or is close to being repaid. The lower the loan amount, the more likely the property will be positive geared.
An interest-only loan could also make a property positively geared and factoring in record low interest rates at the moment and a strong rental property demand increasing rental returns, it will be not uncommon to see positively geared properties even with a large loan balance.
So, unless a property investor can buy a property with a large percentage of their own funds, it’s likely that the property will be negatively geared.
Benefits of negative gearing
1. Capital growth
Negatively geared properties have a good potential for capital growth. The key here is to purchase in locations with a strong likelihood of future growth.
More often than not, the capital growth from a negatively geared property outweighs the losses incurred over time, but caution still needs to be taken on the correct property selection.
There are times when properties have minimal or even negative capital growth, so in these instances, the negative gearing strategy would not be advisable if there is a strong chance that property prices would not increase.
However, if the property is increasing in value over time and you sell at the right time – that is, when the value of the property exceeds the purchase price and costs incurred – then you will have a return on your time and money investment.
Negatively geared properties also offer you the opportunity to add value to your asset immediately through renovations, subdivisions, or other existing building improvements.
2. Tax savings
As discussed previously, the Australian Taxation Office (ATO) allows property investors to offset the negative gearing loss of a rental property against any other individual income. A rental property loss occurs when the costs of owning and operating the asset are greater than the income it produces.
3. Competitive rentals
Because negative gearing property investors are not seeking a positive return in the initial stages, they can price their rentals competitively. This allows them to benefit from long-term relationships with tenants.
This avoids the headache of having to deal with multiple tenants consistently vacating and having to go through the vacate-lease-vacate cycle over and over. Securing long term tenants is a real win. It also reduces the amount of time the property stands vacant.
4. Take advantage of record-low interest rates
Interest rates are currently at a historic low in Australia, making negative gearing a popular option for many investors. Many properties are now only incurring a small loss, making it easier to hold onto an asset, as there is less need to find additional cash to make up any shortfall in maintaining the property. These record low interest rates are also driving up property prices making the property market very strong.
Negative gearing explained
Taylor earns $140,000 per year. She just bought a brand-new investment property for $600,000 from a property developer.
Taylor borrowed 90% of the purchase price and makes fortnightly repayments.
After speaking with a real estate agent, the current market rent for this property is $500 per week.
The council and water rates, insurance and agent fees total $5,000 per year.
Here’s how Taylor’s property investment adds up at the end of the year.
|Council and water rates, agent fees||($5,000)|
|Total cash loss||($1,000)|
|Total tax loss||($13,000)|
Taylor is then able to claim the loss of $13,000 against her personal salary income and reduce her overall tax payable as follows.
|Taylor with no property||Taylor with one property|
|Property tax loss||Nil||($13,000)|
|Tax plus Medicare||($39,847)||($32,057)|
|Net income each year||$100,153||$94,943|
In return, the ATO let her keep an extra $7,790 of her money when lodging her tax return ($39,847 – $32,057).
So, Taylor has paid out $1,000 (Total Cash Loss), to receive back $7,790 in cash from the government. This is why the tax benefit of negative gearing can really help a property investor.
In this example the depreciation deduction has also really helped Taylor generate a tax refund. This is why we strongly recommend speaking to a quantity surveyor when purchasing a rental property.
In this situation Taylor could also use the additional $7,790 refund from the government to repay her home loan down quicker. Combine this with capital growth on the house each year and this strategy will result in building faster equity in the home. This equity could then be used to fund more investment property purchases.
Lastly it is always important to choose the right investment that will suit your particular strategy. Unfortunately, from my experience, too many times, my clients invest in properties with a negative gearing strategy and select a house that they know or is close to where they live, without thinking if this investment is best for property growth.
This guide to negative gearing has considered what negative gearing is, some of the risks, but most importantly, what the benefits are.
Australia certainly is the lucky country and negative gearing offers a range of benefits when done properly. The potential for capital growth, tax savings and the ability to take advantage of record-low interest rates are all some of the reasons why you should definitely consider negative gearing as part of your overall investment strategy.
At Addison Partners, we can help tailor a strategy to suit your goals and situation and introduce you to other strategies that could help you minimise your tax in the short term.
So, if you are looking to make your first property investment or are an experienced property investor, myself and our dedicated tax experts at Addison Partners can help evaluate your portfolio to ensure it is optimised in the most tax-efficient way possible, whilst helping you build quality assets over the long-term.