Borrowing money to invest in property has always been a time-honoured Australian wealth creation strategy. The allure of a brick-and-mortar investment that you can see and touch is also not without merit. There is great pride in owning property. It imbues you with a sense of accomplishment. Most importantly, the value of the property is most likely going to rise, thereby growing your wealth.
An investment property can also be a cash cow. You can sell it or rent it out to offset the cost of owning that property including the interest that you pay on a loan on the investment property.
However, if the costs of servicing the loans or the interest payments on the property are higher than the net rental income (after you have deducted the expenses) that you derive from the property, the Australian Taxation Office (ATO) will allow you as an investor to offset these losses against the income that you have earned from other sources. This is what is called negative gearing and it helps reduce your tax obligations.
Apart from tax benefits that you derive from a negatively geared property, you are also likely to make long-term profit if the value of the property rises to a point where it can cover your capital outlay. The negative gearing strategy is pegged on future capital growth. You are essentially leveraging the tax system to absorb the shock of your losses over the short term. Then in the long term, with capital growth, you will essentially transform the negative into a positive and make a profit.
For an investor, negative gearing comes with the obvious tax benefits. However, there are instances where it may also be a risky investment gamble.
Naturally, the aim of any investment is to generate profit and value for the investor. An investor that has a negatively geared property usually hopes that the rental income from the property is eventually going rise to cover the loan costs or the capital growth at the time of selling. The moment the rental income can cover the cost of borrowing, the property will become positively geared and the income derived from the property will be subject to tax.
Is Negative Gearing Still a Good Strategy?
Negative gearing works perfectly in a market where there is good capital growth. However, gambling on the capital gains in your property might not always work. This is especially so at a time when the global market is seeing greater uncertainty. It could be risky because there are certainly no guarantees for future capital growth on your property in some markets.
Negative gearing could backfire in a stagnant property market. If you factor in low capital growth in such a market and the capital gains tax, you might actually end up making losses. One way of surmounting low capital growth would be for the property owners to focus on creating equity on the negatively geared property rather than just basking in the tax advantages. They could do this by accelerating the payments so as to reduce the amount of the loan and interest payments. That will allow them to start breaking even and making a profit a lot sooner. The equity generated in your negatively geared property can also be used to acquire additional properties.
Negative Gearing Should be Part of a Broader Strategy
While the tax benefits are certainly welcome, it would be ridiculous to purchase property just for the tax savings. Negative gearing should be part of a broader wealth creation strategy. You shouldn’t just be content on saving on your income tax and hoping for capital growth. You can leverage your negatively geared property to acquire more properties, if that is part of your wealth creation plan.
The Risks Associated with Negative Gearing
Negative gearing may not be ideal for all investors even if you factor in the tax advantages. If you are going to finance your investment simply by borrowing money, you will soon fall afoul to the risks associated with borrowing such as rising interest rates that may impede your ability to meet your loan repayment obligations.
To mitigate the risks associated with negative gearing, it is advisable to go for properties that are more likely to increase in value for the investment duration. Your negative gearing strategy is after all based on the expectation of future capital growth.
Carry out extensive pre-purchase research to identify the right properties for investment. It is also advisable to have enough income that will help cover your costs should your tenants be late with rental payments or should your property be vacant for a prolonged duration of time.
When your property is negatively geared, you should also be able to fund your repairs and maintenance costs out of pocket.
Generally, you should only adopt negative gearing if you have the capacity to absorb the potential fall in the price of property values. It is a speculative investment.
The risks associated with negative gearing can be summarized as follows:-
- You could face a cash flow shortage and have to dip into your pockets to finance some of the investment property expenses.
- You may fail to find a tenant and the property remains vacant for an extended duration of time.
- The property market may plunge and you may fail to realize a capital gain as a result.
- You may fail to meet your loan repayment obligations
- Tax laws may change in the future making negative gearing a less viable investment.
When considering the negative gearing investment option, you have to look at all these angles before you take the plunge.
Tax Implications of Negative Gearing
You can claim tax deductions for the expenses that you incur in managing and maintaining your investment property. Even the interest that you pay on an investment loan is tax-deductible. If there is a shortfall, you can offset it with your taxable income, including the income that you have earned from other sources such as a salary.
The fittings and fixtures in an investment property can be depreciated over their effective life and a deduction claimed every year. There are three main categories for which you can claim tax deductions. These include the following:-
- Capital works: If there are any major additions to the investment property, you can claim a capital works deduction of 2.5% per year. In some circumstances, this can be as high as 4%. This percentage is applied on the initial cost of the capital works or a rough estimate of the same and can be claimed until exhausted.
- Revenue deductions: Tax deductions can be claimed on the revenue deductions such as the interest payments on the money that you borrow.
- Building allowances: Building allowances can also be claimed. A good example is depreciation for building works.
Other deductible expenses for an investment property include the following:-
- Land tax
- Pest control costs
- Body corporate fees
- The costs associated with borrowing such as the stamp duty.
- Property insurance costs
- Cost of advertising the property to your tenants
- Commissions and fees paid out to property management agents
- Lawn mowing and gardening costs
- Cleaning costs
- Council and water rates
A capital gains tax will apply on the property upon sale after the deduction of some costs. If there are net capital gains, it will be taxed as an income. However, if the property investment has been held for at least one year, the gain will be discounted by 50% for individuals.
Considering negative gearing as part of your investment strategy? Talk to an accountant Melbourne expert to help you establish if this can be a viable investment option for you given your financial situation.