Negatively geared property investing

There’s been a lot of discussion recently regarding the removal of negative gearing as a tax minimisation strategy but many still don’t know exactly what it entails and exactly how it can help, so the following is an introduction.

When a taxpayer purchases a residential property as an investment the rental income received is included in their assessable income. Many of the costs of earning that income are tax deductible such as advertising, body corporate fees, council rates, cleaning, garden maintenance, insurance, letting & management fees, postage, printing & stationary expenses, travel expenses and water charges amongst others. Some costs are not immediately deductible but are spread over several years such as borrowing costs, special body corporate fees, depreciable assets (e.g. hot-water system) the cost of house construction and improvements (after 1984). Finally some costs are deductible but do reduce the capital gain when the property is ultimately sold.

On many occasions the taxpayer will borrow to buy the property and in this case the interest (but not the principal) is tax deductible.  Where the total deductions exceed the rental income the property is termed to be ‘negatively geared’. The excess of tax deductions reduce the taxpayer’s taxable income and as generally most taxpayers have their other income taxed as it’s earned (e.g. salary and wage income) their end of year tax refund is much greater.

By way of example, if your taxable income is $100,000 (the 37% tax bracket plus the 2% Medicare levy) and you have a $10,000 tax loss from a negatively geared property your refund will be increased by $3,900. Further $10,000 tax loss may not necessarily be a $10,000 cash shortfall as some of the tax deductions may relate to borrowing costs, depreciation on assets and the special building write off (a tax deduction of 2.5%  or 4% of the construction cost of the premises) on which there is no cash outlay.

In some scenarios after taking into account the increased tax refund a ‘negatively geared property’ can be cash flow positive! This outcome is generally achieved by taxpayers with a taxable income greater than $80,000 (including the rental loss), who buy a relatively new premises (to get a high level of depreciation and special building write off) and with high levels of borrowings (greater than 70% of the asset value) with interest only loans. More often than not though, most negatively geared properties create a cash shortfall that must be met by the taxpayer with other sources. Over time most negatively geared properties become positively geared (they add to your taxable income) as the principal on the loan is repaid and the interest expense reduces.

This gradual transition is to be expected as the ultimate goal of any investment is to increase your after tax income. A significant part of achieving that outcome is a capital gain upon the sale of the property. Capital gains has also been a hot topic in the area of tax reform recently and in the next blog I’ll provide an introduction to capital gains and how it applies to residential investment properties.