Smart vs Dumb Negative Gearing
A lot of people have over the years built considerable wealth through smart negatively geared investment, particularly, but not limited to residential property investment. (In this article we will assume a residential investment property from here on).
Negative gearing simply refers to the fact that when you take away the costs of running and owning an investment property from the rent it earns, that there is a loss which you are able to deduct from your own taxable income and save some tax.
The critical concept to understand here is that if your property loses say $10,000 in a year, that whilst you will be able to deduct $10,000 from your personal income, even if you are in the top income tax bracket you will only reduce your tax bill by $4,700. You will NOT recover the full $10,000 you spent. Hence you have still burned up $5,300 of your own cash. Or put another way you have spent $1 to save 47 cents.
Therefore it is crucial when evaluating a negative gearing opportunity that you have very good reasons to believe that the asset will rise in value by an amount greater than what you are losing each year and of course some more again to make the exercise worth doing .
Let’s look at a simplified example
Bob has borrowed $400,000 to acquire a $400,000 property (ignore stamp duty etc. to keep it simple). The loan is 5% p.a. and the annual rent is $20,000. There are annual running costs like repairs, rates, insurances etc of $7,000:
Rent$20,000
Annual running costs$7,000
Interest expense$20,000
Annual loss$7,000
Bob is in the second highest tax bracket of 39% (incl Medicare levy) so he can claim the $7,000 loss in his tax return; and it reduces his tax bill by $2,730 (39% of $7,000). Meaning he is still out of pocket $4,270 every year.
If he holds this property for ten years and then sells the property for $450,000 then the ATO will assess a $50,000 capital gain. They will allow him the 50% general Capital Gains discount so he will only be taxed on the $25,000. That leads to a bill of $9,750. So he is left with $440,250.
However over those ten years, even after he claimed his negative gearing losses in his tax returns he still expended $4,270 each year or $42,700 in total. So unfortunately Bob used up $42,700 of his own cash to only end up with a $40,250 after tax capital gain. After ten years of ownership he went backwards $2,450!!
He alternatively could have chosen not to buy the property, paid tax on the $7K he was needing to inject to run the property each year and just invested in a term deposit which at time of writing in May 2020 may not even earn 2% p.a. and ended up with more wealth.
Now of course Bob could have chosen an excellent property and it may have soared in value, well above the $42,700 he expended in cash holding on to it for the ten years and be delighted with the outcome. Many people over the years have had this happy experience.
The example does however demonstrate how important it is if you are going to negatively gear, to have very solid commercial reasons to believe why the property will be worth materially more in say 10 years time, to make commercial sense. We also need to be mindful that at the time of writing interest rates for borrowing are also at historic lows. This may not remain the case over a time frame as long as say 10 or 15 years. If interest rates do rise materially then the value the property needs to reach when sold needs to be substantially higher again to qualify as a sensible wealth building decision.
If having read this article you are now concerned you may have a property in this category and would like us to analyse the numbers so you can make a fully informed decision on whether to sell or retain the property please don’t hesitate to contact us.
