Negative gearing is encountered in many property investment scenarios, especially residential. So what is it? In a nutshell, it means you are spending more money on your investment than you are getting back. So why would you do this? The answer is that eventually you will make a profit that justifies a negative net cash flow over a period of time.
You run at a loss for part, or all, of your investment’s life and are compensated by a gradual change to positive cash flow as time passes and/or you make a capital gain on the sale of the property that more than compensates you for the net outgoings over time.
But wait, there’s more! In Australia, there is favourable tax treatment of this scenario. A loss incurred like this is allowable against other taxable income. It’s like a legitimate business expense.
Let’s look at an example. You’ve bought a brand new investment property and have a price for all the items that you can depreciate. You rent it out for six months and then it’s time to do your tax return.
|Gross monthly rent||
$430050 @ 6.47% (6 months)
Agents Management Fees
Total Costs $16,862
Costs = $16,862
Income = 6 x $1800 = $10,800
Income – Costs = $10,800 - $16,862 = -$6,062
So you see that you are running at a loss of $6,062 but you’ve done your homework and are sure that in the long term you will make on the capital gain when you eventually sell.
Now let’s look at the depreciations. What does this mean? Certain items in the property will eventually wear out and will have to be replaced. The Australian Tax Office (ATO) regards this as a legitimate business expense allowable against tax paid by the investor. They even issue rates of depreciation that you can use for this process.
Let’s look at how we do this.
Firstly we’ll list the items we can depreciate and the yearly rate that the ATO recommends for depreciation.
Items for Depreciation: Costs and Depreciation Rates
|Hot Water System||$1250||8.3%|
Now we'll calculate the amount of the depreciations.
Depreciation Amounts Over Six Month Period
|Hot Water System||$52|
Now with this part of negative gearing you are not actually paying any money out. You’ve already paid for all these items. What we have here is an estimate of their drop in value due to age, wear and tear. But this is still a legitimate business expense allowable against other tax paid by the investor.
Notice that the building is included in this but not the land. This is the acceptable value of the structure.
Combining the two parts of negative gearing we see that there is a total cost of
$6062 + $3946 = $10,008
If we assume that the investor is an individual paying a high marginal income tax rate on other earned and investment income, the amount of $10,008 can be treated as an allowable expense.
Thus, let’s assume a tax rate of 45% at this time, noting that this will vary with the investor and over time as the ATO can change marginal tax rates:
reduction in tax payable = 45% of $10,008 = $4,504
We did this for a six-month period therefore over a year it would represent a reduction of $9,008
Bear in mind that as the property ages eventually the depreciations will reach zero.
Note also that the higher the marginal tax rate of the investor, the more effective is this allowance.
If you buy an older investment property it may be sensible for you to have these items valued by a professional before you depreciate for tax purposes and get advice from your accountant and financial advisor.
Top 10 tips for finding the right mortgage for you...