There’s a financial strategy that is termed as ‘gearing’ which happens when a property investor acquires a loan to buy a property to be used for rental vs. the owner’s main residence.
Simply put, a buyer utilizes a lender’s loan as a way to make an income, and with it comes a few tax deductions associated with owning the property.
When the investment property produces some profit, while the returns are large enough to include the related costs of overall managing the property as well as the interest repayments of the loan, this property is said to be ‘positively geared.’ But as for the income made beyond and above the costs of running the property, such will be taxable.
Conversely, the property can be on the other side which is ‘negatively geared.’ This means that owning the property is more costly than the income being received. However, these extra costs are claimable, they are considered as tax deductions in your rental income.
Negative Gearing – what it is and what does it cover?
An investment property is said to be negatively geared if after all the depreciation and other expenses are deducted and you come up with the resulting net rental income – it turns out to be smaller than the borrowed funds’ interest.
What usually happens if there is a net rental loss is an effect of a negatively geared property. You can take a loan, purchase a property, renovate or remodel it while faced with costs associated with maintenance. You may realise that the annual rental income you earned is less than all the expenses you have incurred once the financial year ends.
It’s not favourable, but the good thing is you may offset it versus the other sources of income you have — this is essentially the advantage from this loss. The outcome is when your negatively geared property’s loss can be compensated with other sources of income and salary. Per ATO’s opinion, you are earning less beneficially and thus, will pay lower tax when it’s time to file as the financial year ends.
Though it is typical in the field of property investment – you might as well apply negative gearing for other financial activities you may engage in as an investor such as in shares and bonds.
Negative gearing – a sample scenario:
Olivia is a designer but doesn’t have her own business or company.
Through the years, she had accumulated savings enough to buy herself a stylish apartment as an investment in an outer suburb in a slow-gentrifying portion. The present batch of tenants here usually pays $20,000 yearly in rent.
Olivia went on and worked it out initially having a 15% deposit.
This suggests that in debt, she’s extremely geared, and she is obliged with annual interest charges = $25,000.
On top of that, she has about $4,000 to cover for rates, strata expenses, insurance, repairs of the windows, and repainting of the laundry area.
In general, such is a loss of $9,000 yearly which affected her purchasing power and lifestyle (before the investment). Of course, this isn’t quite critical at all though it looks like one.
Olivia could apply the $9,000 loss to lessen her taxable income, thereby also reducing her tax due payment.
But this specific loss’ tax rebate would only be completed at the financial year’s closing (except if she has applied for a different withholding for her PAYG).
With the assumption that Olivia could balance the $9,000 loss vs. taxable income at her 33% tax rate, this would lessen her tax for $3,000. She only needs to shell out $6,000 from her pocket.
Since her ultimate objective is capital growth on a long-term basis, it means that Olivia is quite in good standing of having only a $6,000 loss per year.
This clearly shows how negative gearing works to one’s benefit, though it may seem like a difficult investment approach. But down the road, it’s a steady strategy to take for over a long period.
Is it possible to turn negative gearing into positive gearing – how to do it?
The fact is that taxable income may exceed the tax deductions through the years suggesting that your property can stop being negatively geared.
These are the most typical situations where this change happens:
- Loan principal repayments through time can reduce interest costs on both interest loans and principal.
- There may be a time when there’ll be higher-rent earnings.
- Deductions are higher in the first years of an asset’s use under the ‘diminishing value’ approach for fully-depreciated assets.
How do you calculate the negative gearing loss – what are the steps?
To compute for your loss in negative gearing, do the following:
- Get the total of your property’s income – It usually refers to the amount of rent provided by the property. Multiply by 52 this weekly rent to get the annual figure.
- Get the total of all your property’s expenses – It consists of the mortgage loan’s interest payments, management fees for the property, and maintenance costs.
- Deduct the depreciation costs – Depreciation means the forfeiture or loss you get from the building’s diminishing value and other assets inside the property, such as appliances, blinds or screens, floor carpets, hardwood floor, and more.
A good, competent accountant may assist you to work on your own ‘depreciation schedule’ so you can ascertain how much are the allowable deductions for your depreciation per year.
Can we claim investment expenses as deductions? What are these expenses?
You can normally claim a tax deduction on the investment property’s maintenance and management that can include your loan interest payments. When you have a negatively-geared asset, you can subtract the rental expenses in full amount from rental and other income, your salaries and wages included.
Check out “How to Increase Cashflow?: Go From Negative $3,000+/yr to $21,000+/yr Positive Cash Flow“
Based on your conditions, you can claim depreciation vs. the property’s rental income.
The general rule is that investors can claim deductions in three (3) major categories of their property investments:
- Capital items – These are the huge items such as a plumbed-in new dishwasher and installation of new carpet which will depreciate through time and thus, claimable for deductions for several years.
- Building allowances – This refers to mostly building allowances like depreciation for building works or depreciation through a long period.
- Revenue deductions. Ongoing maintenance costs and your loan interest payments are part of the revenue from which tax deductions are included.
You may check the ATO website for the comprehensive summary of all these deductible expenses, such as the following:
- Extra Deductible Expenses
- Related Borrowing Costs (examples: loan charges and stamp duty)
- Expenses on Capital Works
- Body Corporate Fees
- Repairs and Maintenance Costs
- Depreciation Expenses on Plant and Equipment
- Water and Council Rates
- Advertising Costs for Tenants
- Interest Charges on Loans & Other Bank Fees
- Insurance Fees
- Property Agents’ charges on fees and commissions
- Land taxes
- Pest Control Fees
- Gardening and Lawn Mowing costs
- Cleaning Services’ Fees
Potential drawbacks of negative gearing – what can you expect?
Negative gearing involves many risks, like any other investment strategy. If you pursue a loan to be able to acquire funds for an investment is certainly a risk in itself. You should know the potential pitfalls which negative gearing entails before embarking on this strategy.
We’re listing here these risks that you need to consider before you finally make that move in negative gearing – consider asking the following:
- What happens should you have a shortage in cash flow?
- What happens if you do not have a tenant while your property remains vacant for a significant period?
- What should you do if the property market falls and you do not achieve your planned goals on the capital gains of your investment?
- How about loan repayments, what is your option if you fail to meet them?
- How do you plan for the possibility of varying tax laws resulting in negative gearing being not as financially sustainable for your specific requirements?
Take heart – these questions are just for your evaluation, but not quite a cause for concern. There are measures you can do to mitigate all the risks related to negative gearing. What you can do is to take on a substantial amount of research as you choose your property for investment and pick the one that has potentials, meaning, that will most likely appreciate.
Make sure that the income you will have on the property is big enough to compensate for the interest repayments while maintaining your property at the same time, even in the face of unfavourable conditions. You may discuss these issues with professionals who are experts in their fields: a skilled tax accountant, an astute financial adviser, and a seasoned mortgage broker. These people are there to make sure that you’re making the soundest and best decision financially.