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

First Home Saver Account (FHSA)

"Personally, I tend to worry about what I save, not what I spend." - Paul Clitheroe

Update: May 2014
As of the 2014 Federal budget, the government has announced they will be closing the FHSA to try to get some budget savings. Those that created their accounts before the announcement can still get their bonus for this financial year, but the account will automatically lose the benefits and withdrawal conditions from 2015. (the previous 4 year holding rule)

For those saving up for a house and have a few years (at least 2 – 4+ years) to save up - you cannot beat this savings account in terms of high return and low risk profile.

I highly recommend you look into it. This account is so good that I am making a separate post for it.

You have to be sure you will buy property sometime down the track, it doesn't have to to be in 4 years, if you need more time, that's fine, however note that you can't touch the money after the qualifying period unless you use the funds to buy your first property. If you don't, the money will be sent to your superannuation balance.

§  This is separate from the First Home Owners Grant. If you are eligible for that, you still get that in addition to the earnings on this account.

§  You will get a guaranteed 17% interest for every dollar you put into the account up to $6000. The maximum government co-contribution is $1020 for each financial year (indexed, so the figure will increase over time). This year, if you put in $6000, the government will add $1020. You can contribute more if you like, but only the first $6000 is eligible for the government’s 17% co-contribution.

Obviously you can put in more, its just that the initial $6k will get the special 17% return, but this is each financial year. $6k should be the bare minimum.

§  The government contribution will be received in the financial year after you lodge your income tax return and the FHSA provider files its reports with the tax office.

§  You still get interest from the bank on top of the government 17%.

§  15% tax applies to the interest or growth of the account, but not the government contribution part.. Tax is paid by the account provider.

§  You must keep the account open for at least four separate financial years (they don’t have to be consecutive years) and contribute at least $1000 each year before withdrawals can be made. 4 financial years does not mean 4 years. It can theoretically be 2 years and 2 days if you time it perfectly. For example.

Year 1: Deposit $6k 29 June 2013

Year 2: Deposit $6k 29 June 2014

Year 3: Deposit $6k 29 June 2015

Year 4: Deposit $6k 2 July 2015

Total real world time elapsed 29 June 2013 - July 2015 (just over 2 years)

When you actually deposit the maximum amount that can is eligible for co-contribution, whether right away or all of it just before the cut-off period depends on your marginal tax rate.

If you were on a low tax rate, say 15% or less, then you may be able to get higher interest rates outside of the FHSA, such as online savings or shares, and then dump the earnings into your FHSA before the cut-off. But what if your marginal tax rate was 40%. If you received 7% interest from online savings, your after tax return is actually (7% x 0.6) = 4.2%. If the FHSA account provider was paying 5%, then if you put the funds in your FHSA, your after tax return is (5 x 0.85) = 4.25% - higher than what you would achieve outside of the FHSA environment. In this case it makes sense to deposit your funds periodically throughout the year.

Of course, it is easier said than done to consistently save money. Some may find it hard to save a large amount of money as it is too tempting to use. In that case, I would recommend you periodically set aside money from each pay packet to be sent to your FHSA. Divide $6k or however much it is by the frequency of your paypacket to gauge how much you should be setting aside for savings. eg $6000/12 monthly =$500/month for those that get paid monthly.

Purchase first property 10 July 2015 and able to transfer 4x $6k deposits + 4x $1020 (even more due to it being indexed each year) + 4x interest from the bank for each of the 4 years.

§  The maximum account balance is currently $90,000 (including any government contributions, interest earned, your savings, etc). The figure will be indexed over time and can increase in $5000 increments. Once you hit the max cap, you cannot deposit anymore. $90k is 20 deposit on a $450k house/unit, but you need to factor in any potential stamp duty and other legal fees.

§  You can only withdraw money to buy or build your first home. If you close the account for another reason, its balance is automatically transferred to super. Withdrawals after four years to buy a home, or transfers to super, are tax-free. You cannot make partial withdrawals, it has to be the full balance.

From the ATO website:

Income year	Contribution threshold	Maximum government contribution
2013-14	$6,000	$1,020

Income year	Account balance cap
2013-14	$90,000
2012-13	$90,000

Still not convinced?

Here is a very simple example.

The following graph is from NAB’s savings calculator

Assumptions: Start off with $500 right now. Put this in online savings. For the next 5 years (that is 60 months), we are going to save $500 a month every month for 60 months, and let this earn interest at 5% compounded monthly.  Total cash deposited $30,500, the rest is the interest we made. At the end of the rainbow, you have saved $34,644.72. Not too shabby right? However this is before tax, so you will have to minus out the amount you paid in tax as well over the 5 years.

Now, what if this was the FHSA?

Again, $500 initial deposit, ongoing $500 a month, every month for 60 months. Total deposit again $30,500. The difference this time is that for each financial year you put in the $6k deposits, the government will co-contribute $1020 (indexed each year). That’s at least an extra $4080 over 4 years, even more because you earn interest on the contributions too!

So lets just add up the contributions made to the account, NOT EVEN ANY INTEREST we made on the account. $30,500 + 5*1020 = $35,600. Without any interest being even factored into the equation, you can see that the FHSA has eclipsed the savings of the ordinary savings account.

Change your mind? What were you thinking? Well there is a Cooling-off period

Each first home saver account comes with a 14-day cooling-off period. This means you have 14 days to change your mind, close your account and get any contributions back. In this circumstance you are still eligible to open another first home saver account in the future.

First home owner grant

You can still apply for a first home owner grant if you decide to open a first home saver account. However, being eligible for one doesn't automatically mean you're eligible for the other - there are different rules.

More info: http://www.ato.gov.au/Individuals/First-home-saver-account/

Some of the FHSA account providers include: (Interest correct as of Dec 2013)

IMB 3.82% interest

http://www.imb.com.au/personal-everyday-banking-what-we-offer-savings-accounts-first-home-saver-account.html

ME Bank 3.25% interest

http://www.membersequitybank.com.au/personal/savings_accounts/first_home_saver.html

Hume Building Society 2.5% interest

https://www.humebuild.com.au/personal/accounts/saving-accounts/first-home-saver

AMP 2.5% interest

https://www.amp.com.au/wps/portal/au/AMPAUProduct3C?vigurl=%2Fvgn-ext-templating%2Fv%2Findex.jsp%3Fvgnextoid%3D3cef7fad10112210VgnVCM10000083d20d0aRCRD

Total List of Approved FHSA providers as per APRA

Under the legislation FHSA providers could commence offering FHSAs from 1 October 2008. Authorised Deposit-taking Institutions and Life Companies that are providing FHSAs (according to their websites and by contacting their customer service centre) are listed below.

·         AMP Bank Limited - ABN 15 081 596 009

·         Australia and New Zealand Banking Group Limited (note) - ABN 11 005 357 522

·         Big Sky Building Society Limited (note) - ABN 30 087 652 079

·         Commonwealth Bank of Australia (note) - ABN 48 123 123 124

·         Community CPS Australia Limited (note) - ABN 15 087 651 143

·         Credit Union SA Ltd - ABN 36 087 651 232

·         Defence Bank Limited (note) - ABN 57 087 651 385

·         Hume Building Society Ltd - ABN 85 051 868 556

·         Hunter United Employees' Credit Union Limited - ABN 68 087 650 182

·         IMB Ltd - ABN 92 087 651 974

·         Members Equity Bank Pty Limited - ABN 56 070 887 679

·         MyState Financial Limited (note) - ABN 89 067 729 195

·         Police Financial Services Limited - ABN 33 087 651 661

·         Railways Credit Union Limited - ABN 91 087 651 090

·         Teachers Mutual Bank Limited - ABN 30 087 650 459

·         The Police Department Employees' Credit Union Limited - ABN 95 087 650 799

·         Victoria Teachers Limited - ABN 44 087 651 769

·         Wyong Council Credit Union Ltd - ABN 29 087 650 897