WHAT'S SO GREAT ABOUT NEGATIVE GEARING?
Written by Melissa Browne
I was having a conversation with clients recently and the topic of negative gearing came up. Of course, I launched straight into problem-solving as my kind so often does until one of them asked in a fairly embarrassed voice, ‘do you mind explaining what negative gearing is and why it’s actually helpful for us?’
Negative gearing is such a common part of our Australian vernacular that I simply assumed most people know what it is and what the benefits are. So when I polled this with some friends a few nights later I was surprised when they also shrugged and struggled to explain exactly what negative gearing is. Which made me realise perhaps we’re spouting a whole lot of rhetoric and not actually understanding the substance behind it.
There’s also the myth the government are currently espousing that negative gearing is the domain of the rich and this nasty loophole should be closed so little Aussie battlers can pay less tax. The problem is, certainly in my experience, that it’s often little Aussie battlers who are still actively chasing the benefits of negative gearing.
So what is negative gearing and what is the big deal?
Negative gearing is simply where a loan is used to purchase an asset and there is a loss between the income generated and the interest and expenses. It’s often used to explain a property purchase but it can equally apply to a share purchase or other type of investment. Using property as an example as that is what many people use negative gearing for: if my rent is $50,000 and my expenses are $60,000 then my property would be negatively geared because there is a loss of $10,000. I can then claim that loss potentially on my tax return and receive a tax saving based on my taxable income. So for an average taxpayer the refund or tax saving would be roughly $3,150 and therefore the out of pocket expense would be $6,850 (instead of the initial $10,000).
In theory it’s very simple.
Back when our marginal tax rates were a lot lower, negative gearing was a whole lot more attractive. When the top tax rate is 48.5% and that rate kicks in at $60,000 then almost half of your loss can be clawed back as a tax deduction. The size of that saving made schemes like negative gearing incredibly popular. Nowadays, with most taxpayers on a tax rate between 32.5% and 37% the tax benefits are certainly considerably less than they once more.
Having said that, being able to reduce your out of pocket expenses by one third is certainly nothing to scoff at and means the government is helping you fund your asset purchase. Which is why so many people still view negative gearing as an essential part of their wealth creation strategy. Plus, let’s face it, Aussies love a tax refund.
The benefits of negative gearing often kicks in harder with new homes and apartments. As the asset is new, the depreciation is a lot higher than with an older home so you can claim more expenses without it actually costing you more in terms of dollars out of your bank account. So in the above example you might have say $15,000 worth of depreciation deductions which means an extra $4,725 worth of tax savings. This means your out of pocket expense drops to $2,125. Suddenly negative gearing is making a whole lot more sense.
The problem that I often see is when people become too focussed on the refund and not why they’re acquiring the asset in the first place. They don’t give enough consideration to the fact that the property eventually needs to make them money through a capital gain for this whole thing to work. And if I could have $100 for every person who has told me over the last twenty years that ‘property always doubles every seven years’ then I wouldn’t need to invest in anything other than people’s ignorance.
So how can you make negative gearing work best for you?
1. Consider renting your own home and purchasing an investment property instead. That way you have no ‘bad’ debt or personal debt and all your ‘good’ debt is claimable. Of course, this needs to be weighed up against the fact that any capital gain on your home is potentially exempt from capital gains tax
2. Consider purchasing a newer home or apartment to take advantage of the extra depreciation deduction. Of course this should never be your sole reason for purchasing an asset.
3. Factor in an interest rate rise of up to 8% so you can afford to hold the investment for a longer term regardless of changes in economic conditions
4. Never purchase based solely on 1 and 2 but always with the view of whether or not this is a great long term investment and what the return is likely to be
5. Do your research and consider using a buyer’s agent or a reputable independent property analyst rather than the wisdom of your next door neighbour.
Negative gearing is simply the ability to reduce your taxable income and therefore your tax payable through the losses generated by purchasing an asset with a loan. This tax saving essentially lowers your out of pocket expenses in holding the asset and can make the purchase more affordable.
Of course, negative gearing might sound good in theory but there are many other things that should be considered such as using a different structure (for example Trusts or Self Managed Superannuation) and even who should be holding assets. Therefore, while a tax saving might be viewed as the holy grail by some, it should never be what causes you to purchase an asset.
About the Author: Melissa Browne is CEO of accounting firm A&TA and financial planning firm The Money Barre. Her latest book Unf*ck your Finances released in Jan 2018.
You can contact Melissa on her email or learn more about A&TA or The Money Barre.