Recently we kicked off a series of discussions designed to help inform our readers regarding the tax treatment of property investing in 2021.
We are breaking it down into three stages being –
- Tax Implications of Investment Property Acquisition
- Tax Implications of Investment Property Ownership, and
- Tax Implications of Investment Property Disposal.
In our first post we started with the Tax Implications of Investment Property Acquisition looking at –
- Transfer Duty (previously known as Stamp Duty)
- Goods & Services Tax (“GST”)
- Foreign Residents Withholding Tax
Then we moved onto the Tax Implications of Investment Property Ownership starting with –
- Goods & Services Tax (“GST”),
- Land Tax.
Then we turned to –
- Income Tax (in Demystifying the Tax Implications of Property Investment in 2021 (Continued – Part 2))
Today we continue with Income Tax, this time looking at the often contraversial…
Negative gearing is an aspect of the Australian taxation system that gets a lot of media attention and, in our view, is often demonised unnecessarily.
When people use the term negative gearing, they are generally referring to the tax benefits that can be achieved via property investment. And of course that is what we are going to discuss today.
But the truth is, negative gearing applies to any investment. And the principle behind it is fundamental to Australia’s tax system. Hence why we get frustrated when people argue against it in relation to property.
Because it would be completely inefficient and illogical to remove it in relation to just property investments, while allowing it in relation to other investments that don’t receive the same attention.
So, what is negative gearing?
The term “gearing” refers to funding an investment by debt.
When you take out a loan in order to allow you to make an investment, you are considered to have “geared” that investment.
So, in simple terms, if you buy an investment property for $450,000 and you put down $50,000 of your own cash and you borrow $400,000 you have “geared” your property investment.
The “negative” component refers to the scenario where the costs of holding the investment, which include the interest on any loan used to acquire it, exceed the income earned from the investment in a particular year.
In the example used in Demystifying the Tax Implications of Property Investment in 2021 (Continued – Part 2) Joe incurred a number of expenses throughout the year in relation to his investment property. Those expenses included interest on the loan he used to buy the property. However, the income earned exceeded all those expenses. Therefore Joe was not “negative gearing”. Some might say he was “positively geared”.
But what if the amount of rent Joe received was less…
Illustrative Example 3
Joe Smith owns a property which he rents out for $400 per week (in the previous example it was $500 per week).
All the other relevant numbers are the same as in the previous example…
He purchased the land for $250,000 and spent $200,000 building a house upon it.
He borrowed $350,000 from the bank to do so.
He also spent $3,000 on a fridge, washing machine, clothes dryer and dish washer which he placed in the house for the tenants use.
Joe uses a Real Estate Agent to manage the property.
His taxable income from owning the investment property is determined as follows –
|Rent||($400 per wk for 52 wks)||$20,800|
|Total Assessable Income||$20,800|
|Less: Deductible Expenses|
|Advertising||(Advertising to find the tenant)||$150|
|Bank fees||(On the account into which rent is received at $5 per month)||$60|
|Capital allowances||($3,000 depreciated over 10 years)||$300|
|Capital works||($200,000 amortised over 40 years)||$5,000|
|Interest||($350,000 at 3.5%)||$12,250|
|Management fees||(9% of rent received)||$2,600|
|Repairs & maintenance||$250|
|Total Deductible Expenses||$23,160|
|Taxable Income / (Loss)||($2,360)|
Now as you can see, the expenses exceed the income and a loss has resulted.
This is what is known as “Negative Gearing”.
It is when the expenses related to holding an investment property (or any investment for that matter) exceed the income it generates.
NEGATIVE GEARING REDUCES INCOME TAX PAYABLE
In the previous example in Demystifying the Tax Implications of Property Investment in 2021 (Continued – Part 2), as the income earned exceeded the expenses, the net additional income was added to his other taxable income and therefore resulted in additional income tax payable.
But in the new example above, as a loss was incurred on the investment property for the year, the amount of the loss is deducted from his other income.
So if we assume Joe earned $100,000 from his job, after deducting the loss on his investment property his taxable income reduces to $97,640.
His marginal tax rate (including Medicare Levy) would remain 34.5% meaning that the negative gearing of his investment property will save him $802.40 ($2,360 x 34.5%).
SO WHAT IS THE CATCH?
Well, often potential investors are attracted to the idea of investment properties specifically to receive the negative gearing benefits.
But remember, in the above example Joe has lost $2,360 in order to save $802.40. So he is still behind for the year!
The reason why an investor would accept this is because the expectation (or at least hope) is that the value of the property will have increased by more than this loss, and therefore overall the investor’s wealth has increased as a result of the investment. In this case a mere 0.35% increase in value would be enough to cover the loss for the year.
Having said that…
There is another element to negative gearing that needs to be considered.
Part of Joe’s deductions didn’t actually cost him any cash during the year. They are the Capital Allowances and the Capital Works. Because they represent the allocation of a portion of the original costs of building the property and installing fixtures and fittings.
So his actual cash position for the year, before taking into account tax, was actually positive as follows –
Total Rent Received – $20,800
Less: Cash Outgoings – $17,860 (being $23,160 Total Deductible Expenses – ($300 Capital Allowances + $5,000 Capital Works))
Equals Net Cash Received – $2,940
Add to that the tax saved of $802.40 means the investment has been cash flow positive to the tune of $3,742.40.
So this is where some argue, incorrectly, that mischief exists in negative gearing. As a tax saving has been received while also receving positive cash flow.
But you will see when we discuss the Tax Implications of Investment Property Disposal that over the course of the investment lifecycle, there is no mischief at all.