Between 2014 and 2015, nearly 1.3 million people in Australia recorded a rental net loss, which means that almost 13% of taxpayers were negative gearing. Unfortunately, up until today we had the chance to witness a gradual rise in this trend which mostly affected people on a medium and lower income.
Those who have considered investing in property were bound to come across the term but were unfamiliar with its meaning. After years of industry experience we had the pleasure of meeting clients who presented us with this same questions, which is why we decided to provide a detailed explanation.
What is negative gearing
Gearing is the termed used to describe the act of borrowing money in order to invest it. But when you borrow the money you agree to pay it back in interest. If your investment delivers profit, you are positively geared, whereas people who experience financial loss are negatively geared.
In property investment, negative gearing means that your income is less than an interest rate and other supplementary expenses. In that case, an additional source of income is needed to finance the accompanying costs. Negative gearing often occurs when the market is stagnant or when it falls.
In Australia, it is a common strategy used by property investors who are looking to deduct any income deficiency from an investment that does not cover the maintenance costs and interest expense associated with the asset they invested in.
Here’s what it looks like in practice: An average Australian takes out a mortgage or any other loan type to purchase a property. If the price of the rent he sets is lower than the monthly loan payments, they are entitled to implement a negative gearing strategy, which means that their monthly taxes will be lowered.
If years later the value of the property surpasses the expenses the investor had over the years, they achieve a capital gain which is known as positive gearing. On the contrary, negative gearing occurs when the value of the property remains constant or decreases, which means that by selling it, the owner results in a financial loss.
This problem occurs due to the fact that many investors do not weigh the pros and cons of this practice. Namely, after hearing about the tax benefits they neglect to calculate by how much their taxes will be reduced and whether the amount is sufficient to keep them on the positive side of the axis.
While negative gearing is quite common in a variety of tax systems across the globe, the Australian negative gearing rules are considered a bit problematic. Namely, the data indicates that people on moderate and lower income tend to experience negative gearing more often. The reason behind this is the fact that investors with higher total income get a greater tax deduction from their wages, while citizens who are on a moderate or lower income get lower tax minimization benefits. Consequently, they cannot afford their monthly expenses.
To invest or not to invest
To decide whether or not the investment will produce profit, it is imperative to conduct the cash flow analysis to define:
- Exact tax reduction you can get
- Property value increase you need in order to earn the profit
Here’s all the math you need:
- Calculate your total income by taking your weekly rent and multiplying it by 52 (weeks in a year). The result is the total annual income you will get from the property rent.
- Add all the expenses. While they differ depending on the property in question, some of the most common ones include:
- Land tax
- Strata fees
- Repairs and maintenance
- Mortgage payments
- Bank fees
- Detract income expenses.
- Detract depreciation from the cash flow. Depreciation refers to the lowering in the building value or items inside the building over time.
- Calculate tax refundable or payable. After taking the depreciation into account you will show whether you are positively or negatively geared. In most cases, if your property is negatively geared you are eligible for a tax refund.
Found a property you want to invest in? Whether it’s your first one or you are looking to become the proud owner of multiple properties across Australia, don’t hesitate to get in touch with Paul Flynn Property group to get advice and consult on future steps you need to take.