Negative Gearing - What is it all about?

Negative Gearing

"Money frees you from doing things you dislike. Since I dislike doing nearly everything, money is handy. - Groucho Marx"

You'll often hear about rich investors utilising negative gearing to purchase investments (such as property or shares). Negative gearing is simply getting less income from an investment than what you incur in expenses. The most common example is the income you get from property (i.e. rent) is less than the cost of holding the property (includes interest cost on the loan, strata, and outgoings). Keep in mind these expenses are accounted for in your tax return and reduces the tax you will need to pay. 

On the face of it, it sounds strange. Having an investment which ultimately is losing you money. Let's say if your rental income is $400 a week, which is about $1732 a month. During the same month, your interest charges is about $2000 a month. For simplicity we will assume no other expenses or outgoings for the time being. We can see that the deficit is $268 a month ($2000-$1732) which we have to pay out of our own pocket.

So in your tax return, you declare the $20,800 in rent that you received during the financial year. Expenses, for simplicity, would be $24,000 resulting in a yearly loss of $3,200.

Now, let's say your taxable income from salary/work is $60,000 a year. Adding the $20,800 rent, but then deducting the expenses of $24,000, results in taxable income of $56,800. So we will pay tax on the $56,800 at your own marginal rate (you'll immediately see we will pay less tax as we have lower taxable income). Effectively we save tax of $3,200 times your marginal rate. At 2014-2015 rates, this is on the 32.50% tax bracket, so $1,040 tax reduction is obtained. The net cost of this investment is $3,200-1,040 = $2,160 a year.

This is the main reason why investors have a big advantage over someone that buys a house to live in, also known as the principle place of residence ('PPOR'). While the investor can deduct the interest expense they incur in their tax return, the PPOR purchaser does not have this same benefit. This is also a reason why interest only loans appeal to investors. They can have the maximum deductions on their tax return due to maximising the interest they pay. They want to maximise tax deductible debt, while minimising non tax deductible debt such as the one on the PPOR. 

Now, there's a few scenarios that can occur over time:

After a while, 2 things occur which should hopefully mean your once negatively geared investment becomes positively geared. The first is that as your loan balance reduces, your interest payments to the bank also reduce. The second factor is that rents are expected to increase over time to reflect inflation and market demand for the area. These factors can mean the income you receive from the investment is more than the expenses you incur from having this asset in your possession.

The return on investment has 2 sources of value – one is the income stream from the rent, and the second is the potential capital gains from the increase in value of the property. In a few years, the investment may still result in yearly losses for you. However, as the Sydney property market has shown, property prices can increase significantly over the course of a few years and this has been the case for pretty much every suburb in the state. Heck, most of the country has experienced surging property prices. The ‘gamble’ is that property capital gains will outweigh any loss during the waiting period or that the income stream will increase by enough.

• o   Let's say after 5 years, your property has increased by $250k. Assume that during this time the rent hasn't increased as much as the home value so chances are your property may be still negatively geared
• o   If we continue with our example, with yearly after-tax expense of $2160 a year, then over 5 years, we are $10,800 out of pocket due to the investment
• o   Should we decide to sell, the after tax profit at year 5 would be $250k increase in value, less tax on the discounted capital gains balance (‘CGT’), less the $10,800 we incurred over the 5 years. A very simplistic explanation of how CGT is calculated is that it is the difference in value when we sell the investment and when it was purchased. When it is held for over 12 months, you pay tax on 50% of the gain at your marginal rate, instead of the total difference.
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Now, here’s the kicker. You don’t even have to actually SELL to unlock the value from the investment when it has increased in value. What many people do is refinance their existing loan to borrow more money. The value of the property has increased so the bank is generally willing to lend more to you. Where previously you borrowed 80% of the original value, if your property did increase by $250k over this period, you then can borrow up to 80% of the new value which the bank will decide based on a valuation. If we use an original value of $500k and new valuation of $750k, the amount you can borrow is up to $600k (which is 80% of $750k). If you use these funds to pay out the old loan, you have potentially $100k to play with – to contribute to your next investment.

Why I believe property prices will continue to increase:

1.     Simple supply vs demand. Majority of people want to own their own place. There is only limited amount of houses/land in Australia in the desirable suburbs, so you will have to compete with others to secure the place you want. Sure – there’s heaps of apartments being built, however they too are limited in how many can be built in one location and apartments may not suit everyone eg, families.

2.     As the population increases, demand for property increases which places increased pressure on prices. Why will the population increase? Well Australia is a fantastic country – we always get net increase in migration. People live longer.

3.     Property has done exceptionally well for investors and PPOR owners alike, and there is nothing to suggest to the good times will stop anytime soon. People stick with what works and what they consider to be safe.

4.     A lifetime of rental is not practical or smart. You’re effectively paying someone else’s mortgage and a prisoner to their choices. If you’re still renting and approaching retirement age, with minimal savings, you’re gonna have a bad time. If the pension or personal savings doesn't sufficiently cover the ever increasing rent and outgoings, you will have to supplement your income via work or other money making ventures, when you should really be looking forward to your retirement