Long Property

The idea of abolishing negative gearing has been discussed in recent months as there is a belief that it is responsible for the house price surges in Sydney and Melbourne. Many have also blamed negative gearing for making housing unaffordable for ordinary Australians.

However the Australian Government has been reluctant to make changes due to the sheer size of the residential property market in Australia (at $6 trillion it is four times larger than the Australian stock market, making it proportionally a lot bigger than in other developed economies) and the damage it may cause to the overall economy. This gives property investors a great deal of protection over policy changes that would otherwise disadvantage them.

The counterargument is also that by encouraging investment the supply of rentals increases, which keeps rent low. Lower rents benefit renters more than investors. Lower rents give renters the opportunity to save more for a deposit on their own home, and by abolishing negative gearing it’s conceivable that rents would go up (there would be less supply of rentals and investors would demand higher rents to make up for their losses), which would benefit investors.

Australian property has established a strong track record as a low risk high yielding investment, particularly for those who take a long term approach. You can see it and touch it, and our historically low interest rates have made it less expensive to borrow.

Negative gearing does play its own part though in explaining Australia’s love affair with real estate.

This post demonstrates how negative gearing works, it also explains some of the risks and recommends sensible ways in which it can be used.

How negative gearing works

Negative gearing is where the costs of owning/operating/running an investment property outweigh the income, and this net loss is used to reduce an investor’s taxable income. It is therefore an investment strategy whereby tax benefits are achieved and then there’s further upside if the property increases in value.

There are two classes of costs associated with running an investment property, both of which are tax deductible:

Cash costs:

• interest payments to the bank (on investment loans) and other bank fees
• ongoing repairs and maintenance
• insurance premiums
• property management fees

Non-cash costs:

• depreciation
• depreciation refers to the fixtures and fittings in an investment property which wear out or “depreciate” as they get older over time. The Australian Taxation Office allows owners to claim this cost as a tax deduction, even although it’s a cost which doesn’t involve any cash payments. Generally speaking the newer the property the greater the depreciation levels, however it is always useful to obtain a depreciation schedule prepared by a quantity surveyor to maximise deductions.

If you add the amount of cash and non-cash costs you get what’s referred to as “all up running costs” of the investment. If this exceeds the rental income then there is a net loss which can be used to reduce an investor’s taxable income.

An example of negative gearing

In the above table we have a $600,000 investment property which rents out at $462/wk, or generates $24,000 income per year. This is based on a 4.00% rental yield and assumes the property is rented out 52 weeks in the year.

If the combined cash cost to run the investment equals 5.50% (this includes the interest rate, repairs/maintenance etc.), then it will cost the investor $26,400/yr cash to run the investment. The property generates $24,000 income so the cash cost/loss is $2,400/yr pre-tax.

The letters beside each figure shows how the calculations have been made.

The second yellow row shows the effect of depreciation. The rental income received is still $24,000 however the all up running costs now increase from 5.50% to 6.50% ($31,200 over the year), to account for depreciation.

So instead of the investment costing $2,400/yr to run the true cost to the investor is actually $7,200/yr pre-tax, even although the out of pocket cash cost is still only $2,400 pre-tax.

This $7,200/yr cost is tax deductible and the benefit of this deduction for investors in each of the Australian tax brackets is illustrated below.

As you can see by moving from left to right across the table, the benefit of negative gearing is greater for investors on higher marginal tax rates (e.g. for investors who earn higher incomes). This is because they are saving a larger percentage of equal costs (e.g $2,400 cash, $7,200 all up).

Therefore the post-tax costs of running the investment properties is less for higher income earners (see the cells highlighted in green).

The tax benefit of negative gearing is calculated on the total running cost of $7,200 (including depreciation), but this benefit is deducted from the $2,400 cash cost of the investment to reach the post-tax figure. Note that for investors in the 37% and 45% tax brackets, the post-tax cost is negative, implying that the investment is negatively geared but actually cash flow positive for the investor after tax.

The fact remains though that in a typical negative gearing situation the investor is going backwards. This is because the income they receive is less than the costs of running the investment. Therefore they are reliant on the investment property increasing in value to make up for, and hopefully exceed, the loss in year to year income.

Should prices go up, investors can realise their gains by selling their investments, however these gains are also taxed (“capital gains tax”), so it’s the investor’s after tax gain (on both income and capital appreciation) that really matters. If the property has been held for less than 12 months the capital gain is simply added to the owner’s taxable income and taxed at their marginal tax rate. If the property has been held for longer than 12 months then investors benefit from a 50% capital gains tax reduction.

The tax paid on income and capital gain from an investment property is dependant on the ownership of the property. For example even although a couple may be joint borrowers and both servicing the loan together, if the ownership is say 100% with one person in the relationship, then the tax liability rests with that person only. This gives rise to a number of strategies relating to ownership structures for investments, they are beyond the scope of this post but will be covered in detail another time.

One final consideration is that over time investment properties often convert from being negatively geared to being positively geared. A common reason is that over time rents rise and depreciation costs fall. There are no longer tax benefits however most investors would rather pay tax on profits (due to higher value/rents), than make a loss. This investor also becomes less reliant on further capital gains to make money, as they are now making money every year they continue to run the investment.

In summary

Choosing the right property to buy is critical when it comes to negative gearing because at the end of the day the change in value in the investment property makes all the difference. If the value of the investment property remains the same, then regardless of whether you’re rich or poor, any investor who negatively gears a property is going backwards.

If the property values actually decrease, then the negatively geared investor loses twice (on income and equity). The importance of selecting a good property, in the right market, at the right time is paramount. Obviously this isn’t straightforward, and even the experts make mistakes, however one can at least “control the controllables” by consulting the right people and doing their own homework.

Another school of thought is to focus less on the tax advantages of negative gearing, and more on creating real equity in one’s investment property by accelerating payments to reduce loan balances (you can read how this is achieved here). Equity can be leveraged to pursue further investments in grow wealth. This becomes more important in stagnant or declining markets where investors have to work harder themselves to create equity (the rising market doesn’t do it for them).

Negative gearing is recommended for those who have sufficient income to cover the all up running costs of the investment, and who can withstand the risks:

• tenants being late on payments
• the property going untenanted for extended periods
• higher interest rates
• potential falls in property values

For these people it offers an attractive opportunity to reduce taxable income in the short term, and then profit over the long term.

If there is a need to reduce house price growth in Sydney and Melbourne, rather than abolishing negative gearing the Government should implement policies to increase the supply of housing (e.g. simplify the council planning system, increase infrastructure coverage) and reduce costs (e.g. stamp duty).

In future posts we will examine a number of negative gearing scenarios to give readers a better feel for the money they require to buy/run investment properties, and the returns necessary to make them successful investments.