Globetrottie 

The Power of Negative Gearing

 

In property investment terms, borrowing money to finance the purchase of a rental investment is similar to shifting the gear in a car to get it to  move faster, or using the pulley to lift that heavy load singularly. A small deposit is ‘geared’ up with a loan to enable the investor to acquire a rental property investment that would otherwise not have been possible. 

 

Gearing into an investment property can be ‘positive’ or ‘negative’, depending on whether the interest expense will result in a net rental profit or net loss after all expenses are covered.

 

A negative gearing strategy trades off tax deductible rental losses during the ownership period against a projected capital gain on the sale of the investment property. For example, a person earns $50,000 a year.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Based on the Australian Tax System, he then pays

 

[19% x (37000-18201)] + [32.5% x (50000-37001)]= $3572 + $4225 = $7796 in TAX! 

That's a lot! So, if he buys a property which is negatively geared, (ie. rental income cannot cover cost/depreciation), then he can reduce his tax. 

 

For example he buys a house ($500,000) to rent out. He pays water rates, interest on the mortgage, maintenance, furniture for the tenants. He can also claim for the depreciation of the building. So let's say he rents it for $300/week and gets $14400 per annum. However his expenses are $30000. Technically he is making a loss of $30000-$14400 = $15600.

 

Let's assume he has no other claims like Family Tax Benefits and other rebates. He is just a regular bachelor going about his mundane office job, often scratching his armpits at his desk, or at the pantry. (We all know that someone!) 

 

Based on his income of ($50000-$15600 = $34400), he pays only $3077 in tax. His tax has effectively HALVED! 

 

Let's take it a little further and say he owns 2 of such properties, ($50,000-$15600-$15600 = $18800). His taxable income has reduced and he pays ONLY $114 in tax!

 

Hey, it doesn't make any financial sense, does it? It seems like he keeps losing money just to save on tax? The amazing thing happens when the property appreciates. The equity in the capital gain can be used to finance the next property. That's how a portfolio grows.

 

A ‘positive gearing’result producing a net rental surplus/profit instead of a loss will be achieved if, for example,the net rental expenses are only 1% ($5000) and the interest rate is at to 5% ($20,000 based on 80% loan of $500000, which makes $400000). After taking depreciation into account, additional cash from the tax savings will have been generated.

 

For tax benefits to contribute positively, the investor has to be on a high marginal tax rate. He also has to have enough cash to cover the cash rental loss each year of ownership. 

 

Risk areas associated with negative gearing strategies include interest rate fluctuations and net capital growth (if intending to flip) not exceeding rental losses.

 

As the tax-free threshold is at $18,200, negative gearing strategies will not suit those with a taxable income below this amount. The benefits are low for those on the 19% (+1.5% Medicare) rate with taxable incomes between $18,200 and $37,000.

 

Is negative gearing for you?

 

In my experience,I have found that negative gearing strategies have worked well for investors who purchased well-positioned properties and held on to them for a long time,riding at least one property cycle,if not more. Very high inflation increased the value of the properties, while the value of the loans fell as increased income made serviceability easier. Other investors who benefited were those who bought well in the first place.

 

Investors who suffered were those who used negative gearing strategies to acquire properties that did not grow in value. In the process they used their earnings to cover annual rental losses. CHOOSE WELL!

 

Others who fared worse were those who purchased with rentals guaranteed for a few years by the developer. Soon after this period expired, the property value was below not only the purchase price but, worse,the outstanding loan. Selling the property meant the proceeds were not sufficient to repay the loan. 

 

In slow growth periods, investors can manufacture capital gain with renovations or improvements that can immediately improve rental yields. Given the high demand and short supply of rental accommodation, a very popular strategy at the moment is to erect a granny flat at a property on a larger block. If the location is good, you very well may be able to double your rental yield!

 

Because of the positive net rental income it generates,the granny flat strategy is being adopted by those who do not have excess cash from their salary to support a negative gearing strategy but have limited deposits to start investing. These properties are generally further away from the CBD so they are cheaper to buy. Investors are therefore buying more of them, generating an income stream even though they are not accruing capital gain – at least in the short term.

 

It is generally accepted in the industry that negatively geared properties are better properties and better located, with expectations of higher capital gain compared to positively geared properties that are cheaper to buy but situated in low capital growth areas. Because it costs little to hold especially when using an interest-only loan, positively geared strategies are adopted by people who want to receive a positive income stream to live on or to use to pay for rental losses of negatively geared properties in their portfolio.

 

HOW SHOULD WE GO ABOUT INVESTING?

 

Build a strong base of maybe 10 good properties, though they may be more expensive, just to make sure they won't suddenly depreciate even when the economy is down. Negatively geared will be good to save on tax. It is like the Australian government encouraging people to invest in real estate, saying "don't pay tax to me. Use it to grow your wealth in real estate!"

 

Using the increased equity over the years, purchase other properties. Your second batch of properties can be high in rental yield but almost no capital appreciation, typically apartments and townhouses in urban town areas. With the rental income, pay off the principal sum of the first batch of properties which you want to keep. Dispose the second batch when they are of no use to you. 

 

Subsequently, for instance, if your first batch of properties are 50% paid up, just sit on the equity and wait for the next property cycle. At any point of time, if there is a good opportunity, extract the equity and go for it. Having a strong base means you have to power to buy at any time, especially when facing a seller who is in an urgent sale, it means you can strike a bargain, just because you can! If you are feel adventurous, start developing properties. Buy a land, build a small project then move on to townships and so on. 

 

If you are chill and wanna retire on 5 fully paid properties, each about 1 mil in value by now, just sell off 5 and pay off the other 5. Collect your passive income and chill man...Feel free to dual-key (dual occupancy) or even triple key your units, to get a higher rental income. However, note that it will be hard to sell because those who pay a good price (usually local families), don't want a triple key house as a family home! (But anyway, you wanna retire already mah...You wouldn't sell those units.)

 

It's such a long post, but if you have strategies you want to share with me or contribute to this blog, my email is sereneteoh@gmail.com. Hear from you guys soon!