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Positives and Negatives of Gearing

Posted on 18 September 2019
Positives and Negatives of Gearing

Positives and negatives of gearing

Negatively gearing an investment property is viewed by many Australians as a tax effective way to get ahead.

According to Treasury, more than 1.9 million people earned rental income in 2012-13 and of those about 1.3 million reported a net rental loss.

So it was no surprise that many people were worried about how they would be affected if Labor had won the May 2019 federal election and negative gearing was phased out as they had proposed. With the Coalition victory, it appears negative gearing is here to stay for the foreseeable future.

While that may have brought a sigh of relief for many, negative gearing is not always the best investment strategy. Your individual circumstances will determine whether negative gearing is an advisable strategy. For many, it may pay to positively gear.

So, what is gearing?

Basically, it is when you borrow money to make an investment. That goes for any investment, but property is where the strategy is most commonly used.

If the rental returns from an investment property are less than the amount you pay in interest and outgoings you can offset this loss against your other assessable income. This is known as negative gearing.

In contrast, positive gearing is when the income from your investment is greater than the outgoings and you make a profit. When this occurs, you may be liable for tax on the net income you receive but you could still end up ahead.

While negative gearing may prove tax effective, it is dependent on the after-tax capital gain ultimately outstripping your accumulated losses.

The importance of capital gains

If your investment falls in value or doesn't appreciate, then you will be out of pocket. Not only will you have lost money all the way through the ownership by having to meet the shortfall in rental income, but you won't have made up that loss through a capital gain when you sell.

That's the key reason why you should never buy an investment property solely for tax breaks.

But if the investment does indeed grow in value, then as long as you have owned the asset for more than 12 months, you will only be taxed on 50 per cent of any increase in value. This is, of course, another plus.

When it pays to think positive

If you are retired and have most of your money in superannuation, negative gearing may not be so attractive. This is because all monies in your super are tax-free on withdrawal. And thanks to the Seniors and Pensioners Tax Offset (SAPTO), you may also earn up to $32,279 as a single or $57,948 as a couple outside super before being subject to tax.

It makes more sense to negatively gear during your working years with the aim of being in positive territory by the time you retire so you can live off the income from your investment.

While buying the right property at a time of your life when you are working and paying reasonable amounts in tax may make negative gearing a good option, sometimes positive gearing may still be a better strategy.

Case study

ASIC's MoneySmart website compares two people each on an income of $70,000 a year. They each buy an investment property worth $400,000, paying interest at 6 per cent a year. Additional expenses are $5000 a year while the rental income is $500 a week.

Rod negatively gears his property, borrowing the full purchase price; Karen is positively geared with a loan of just $100,000. In terms of annual net income, Rod who negatively geared is worse off than if he had not invested in a property at all, with net income of $52,868.

Positively geared Karen ended up $10,000 ahead, with net income for the year of $64,433.

Of course, if his property grows in value over time, Rod should ultimately recoup some or all these extra payments. But if the property doesn't appreciate, then he is out of pocket.

  Rod and Karen's income before buying property Rod's negatively geared property Karen's positively geared property
Salary $70,000 $70,000 $70,000
Plus rental income   $26,000 $26,000
Less interest   -$24,000 -$6000
Less property expenses   -$5,000 -$5,000
Taxable income $70,000 $67,000 $85,000
Tax + Medicare Levy -$15,167 -$14,132 -$20,567
Net Income $54,833 $52,868 $64,433

Assumptions:

- Tax + Medicare levy includes the low and middle income tax offset.

- Example reflects the interest payable in the first year. Over time this will decrease but so will the tax benefits.

- It does not take into account inflation, increases in rental income or changes to interest rates or income tax rates over time.

- Capital growth is not taken into account as it does not affect income calculations. The same capital gain would be applicable under either scenario.
Source: MoneySmart

Claiming expenses

If you choose to go down the path of negative gearing, then it is important that you make sure you claim everything that is allowed.

For investment property, this includes advertising for tenants, body corporate fees and charges, gardening and lawn moving, pest control and insurance along with claiming your interest payments. Of course, it's important to keep accurate records of your expenditure.

As already mentioned, negative gearing is not confined to property. You can also negatively gear investments in shares and claim a tax deduction for interest and other costs, although the risks are greater as it is a more volatile investment.

If you want to know whether negative gearing is the right strategy for you, then call us to discuss.
Tags: investments Tax deduction Property Negative gearing Rhodes Docherty Taxation
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