Negative gearing is a rising trend among investors. People who want to purchase investment properties often need to borrow money from lending institutions. When people borrow, they calculate the risks and potential rewards carefully. Most ordinary investors will try to ensure the monthly profits from their investment property will surpass the mortgage repayments and interest rates.
Negative gearing doesn’t follow the same rules. People borrow money knowing that the profits from the property won’t cover the monthly interest and mortgage repayments. Investors make up for the shortfall between the interest payments and income earned with the help of deductions from their current income tax. Negative gearing is prevalent in Canada, Australia, and New Zealand because of the tax policies and concessions in these countries.
What is the benefit of negative gearing?
Why would you invest in a property that doesn’t offer profits that actively cover your expenses? Even if you get a tax break from the government, you don’t earn enough profit through rent to justify the initial investment. Here’s what you need to understand about negative gearing:
- Negative gearing works because investors don’t intend to retain the property over the long-term. Their investment only bears fruit after they pay off their loan and sell the property.
- For negative gearing to be profitable, the property must be a part of a thriving housing market. Property values should increase over time instead of remaining steady or decreasing.
- If you purchase the right property in the right market, you can potentially earn several hundred thousand dollars in profit. This investment is risky and can potentially lead to complete loss of money.
- Investors need to plan carefully and ensure they have enough financial stability to bear the shortfall between interest rates and income even with the tax break.
Negative gearing is a financially sound decision only if your capital gains are greater than your initial investments and related expenses.
How does negative gearing work?
You need to consider a number of factors before you invest in negative gearing. If you don’t plan your investment well, you can face losses amounting to several thousand dollars. Here’s what you need to consider:
- The total income from the property. For this, you need to multiply the weekly rent by 52 to calculate the annual income.
- Tally all expenses including mortgage repayments, vacancy, repairs, insurance, manager fees, bank fees, council rates, water rates, land tax, strata fees, and property improvements costs.
- Subtract the total expenses from the income. Deduct depreciation as well.
- Calculate the amount of tax you need to pay and determine how much of it will be refundable.
- Consider the capital growth of the property in the market.
All of these factors will help you determine the capital gains from your investment. If you don’t perform these calculations, you won’t know if the property is worth investing in and whether you will get enough money to justify the investment. This is how negative gearing works and delivers profit. It relies solely on the market demand and supply as well as the growth in property rates.
An example of negative gearing
It’s not easy to understand how negative gearing works without considering a real-life example. Here is an example that illustrates how you can earn profit using this investment strategy:
- You purchase a $440,000 property on a loan of $400,000 with 7% interest rates. Your interest will be around $28,000.
- If you earn around $450 rent every week on this property, you earn $23,400 in annual rent income, which leaves you with a shortfall of $4,600.
- If the value of the property increases by 10%, you gain a profit of $44,000 at the end of the year and once you remove the shortfall of $4,600, you have an overall profit of $39,600.
- You can deduct the other expenses from this calculation and still get ample profit at the end of the year.
If the value of the property doesn’t grow by 10% or more, you won’t gain enough profit to justify your investment.
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What expenses can you claim as deductions?
In most cases, you can claim a deduction for any expenses related to the management and maintenance of an investment property, this includes any interest you pay on loans. When your asset is negatively geared, you may be able to deduct the full amount of rental expenses against your rental and other income, including your salary and wages.
The rule of thumb is, property investors can claim deductions in three main categories:
- Building allowances – in most cases you can claim building allowances such as for depreciation over time
- Revenue deductions – you may be eligible to claim revenue deductions such as the interest on borrowed funds
- Capital items – major items such as a oven or dryer in a rental property are subject to depreciation over time and can be claimed over several years
Are there any changes in negative gearing in 2021?
The 2021 budget includes a number of measures relevant to property investors, however it doesn’t directly address or change existing arrangements around negative gearing.
How does this affect Australians?
Negative gearing is still a good investment option for Australians, particularly if you have enough financial stability to support the shortfall between the interest rates and the income generated. The housing market is on the upward trend so you can expect the value of the property to grow comfortably over a short period of time.
It’s a good idea to consider a short-term investment instead of long term investment if you intend to use negative gearing. Most people only invest for one year and see several thousand dollars in profit. This can keep you safe from any changes to regulations the government makes in future years.
