The term ‘negative gearing’ is about as Aussie as a sausage sizzle, with many Australian’s reducing their tax bill through property investment. Read on to find out how negative gearing works and if you should invest in property to save tax too.
What is negative gearing?
Quite simply, negative gearing is where an investment costs you more to own than what it produces in income. In other words, it loses you money. What all the hype is about, however, is that you can claim that loss in your tax return and get some of it back. If you have a property that is depreciable, then you get back even more. In some circumstances, you may get enough back on your tax to cover all of your losses.
How does depreciation help you save tax?
You may be wondering how a property depreciates when all you read in the media is that property is going up. But depreciation is not about the value of the property decreasing, rather it’s the tax write off you get for the wear and tear on the property. For example, the carpets will eventually need replacing and you’ll want a lick of paint on the walls.
You can claim the deterioration of these items early by getting a depreciation report from a quantity surveyor. This is a non-cash cost and can make the difference between a property costing you thousands of dollars per year and only a few hundred. You can even get this money back from the Australian Taxation Office (ATO) early and have your employer take less tax out of every pay so that you net more cash in your bank account. This alone has made property investment affordable for many people in the past.
An example of how negative gearing works
Here is a quick example. The annual rent received on your property is $20,000. The interest on your loan is $19,000 and the costs (such as council rates, insurance etc) is $7,000. In this situation, you’re losing $6,000 per year. If your property has $5,000 in depreciation per year, then your total taxable loss is $11,000. When you submit this in your tax return, assuming you’re in the top tax bracket, you get back $5,390. Don’t forget, the cash loss was $6,000 so after getting your tax return back, you’re only out of pocket by $610 per year.
So should you invest in property to save tax?
It sounds good, doesn’t it? While saving tax is a national hobby, if it’s your sole purpose of buying a property then you’re probably going about it the wrong way. The primary focus when making any investment is to either produce income, growth in asset values or a combination of both. Negative gearing is about losing money and getting the ATO to pick up some of the tab.
It’s certainly possible that a great property can be negatively geared. But if you’re considering investing into property, it’s important to initially put the tax benefits aside. Instead, focus on whether it’s the right investment vehicle for you. Is borrowing hundreds of thousands of dollars suitable for your circumstances? What would you do if the tax rules changed? Can you cope with rising interest rates or a property that is untenanted for a period of time? Do you have the time frame to invest and ride out any negative patch in the market? These are much more important questions to consider than whether you should simply invest in property to save tax.
What you should focus on when buying property
If you decide to go ahead, focus on the quality of the investment, rather than its tax deductibility. To create wealth and income, you should find a quality property in a good area that will rent well. In a real-world situation, you may find two properties which are equally as good as each other. Their location would appeal, they would be within your window of affordability and both present well. If the only difference is that one is more tax-effective than the other, then you’ll likely get a better return on the more tax-effective investment. If, however, the less tax-effective property is a superior property, it will probably be a better investment over the long-term.
The most important thing for any investment is to have a strategy and take an active approach to minimising the risks. Once you have done that, buy the best possible assets for your situation. Ignore the media hype and marketing terms and just focus on quality.