Tax and negative gearing are very important considerations for your loan structure. Although tax is generally considered to be one of the most uninteresting topics imaginable, a clever loan structure can have a very exciting effect on the amount of tax you pay. So, you should definitely be aware of the role of tax in your financial decisions.
Generally, we need to consider the effect on tax when someone is investing (be it in property, shares or business), or intending to invest in the future. In most cases this relates to property, even if it’s just that property is being used as security for borrowings for other types of investment.
In simple terms, negative gearing occurs when the cost of owning a property (or other asset) is greater than the income it earns you, meaning you have a cashflow deficit.
In an ideal world, an investment property would be positively geared (i.e. earn more than it costs you), and would also grow in value each year. In reality, some properties will be high earners but not in areas where values grow much, or vice versa. The ideal win/win scenario is very hard to find. As a result, to acquire properties in good areas that will grow in value, you will usually have to cover a shortfall between the rent and the expenses.
There are essentially two reasons to negatively gear:
- To invest for your future
Instead of putting money into savings, one strategy is to put that money towards assets that might grow at a greater rate than money in the bank. Therefore in some ways a monthly shortfall between income and expenses on an asset is a forced regular investment in future gain, provided that the asset grows in value.
The Australian government has chosen to incentivise borrowing for investment by offering tax breaks. This is part of a greater strategy to encourage people to invest, which reduces demand for government pensions and public housing. When you are negative gearing, the Australian Tax Office allows you some of your cashflow loss back at your marginal tax rate, thereby saving you tax.
Negative gearing works better for some than for others. Its usefulness depends on a few factors:
If you are earning $15,000 per year your marginal tax rate will be very low, meaning that you would get very little benefit back through negative gearing. On the other hand, if you are earning significantly more than that, a negatively geared investment property might even bring you into a lower tax bracket, thereby saving you a considerable amount of tax. It is generally expected that your income will increase over time though, so even if you can’t save much tax right now based on your income, there is still potential for savings in the future. You should discuss this situation with your trusted advisers.
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Your retirement timeframe
If you are planning to retire in a couple of years, your tax-paying time is probably limited. This means that the timeframe that negative gearing will actually be effective for you is also limited. It may not be the right strategy for you, in that case. But again, discuss this with your trusted advisers to find the right plan for you.
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The age of the property in question
There are both cash expenses (interest, insurance, rates, body corporate fees, management fees, repairs and maintenance, etc) and non-cash expenses (depreciation) applicable to an investment property. All of these expenses contribute to the overall annual cost associated with a property. In the case of depreciation, this cost is not something you pay out of your own pocket each year, but an acknowledgement of the fact that buildings, fixtures and fittings decrease in value. Newer properties tend to have much higher depreciation benefits associated with them, which makes them more effective from a negative gearing perspective than older properties.
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