It is a term that might sound complicated, but it’s really quite simple – and it can have massive benefits for investors.
Blogger: Peter Gianoli, general manager, Investor Assist
Whether you’re new to the property investment market or have been in the game for a while, many investors are intimidated by the connotations associated with “negative” or “positive” gearing so we prefer to consider an investment strategy that focuses on “tax effective geared investing”.
Although it sounds technical, it’s actually a simple process that can save you thousands of dollars, come tax time. It’s time to debunk the meaning of “negative gearing” and start to think about “effective gearing”. To do that, we need to take a closer look at negative gearing and understand all of its elements.
What is gearing?
Put simply, gearing relates to the specified ratio of debt in an investment to the value of its equity.
Gearing arises when you have an available sum of money which you use as a deposit to borrow a greater sum of money. You then combine these two amounts together to purchase an investment property (debt + equity).
This investment is then known and referred to as “geared”, as the amount of money you had available has been “geared up”, allowing you to purchase an investment property worth more than the amount you had available. In essence you have borrowed money to fund a larger investment and this known as “gearing”.
What is negative gearing?
Negative gearing simply means your annual return on your investment property is resulting in a loss – you are out of pocket. This is usually the case when you are spending more money on the property than the income it brings in via rent. There are two parts to this equation – the costs and the income.
The costs (what you spend):
- Interest costs on mortgage repayments
- Property Management Fees
- Lenders Mortgage Insurance (LMI) fees
- Travel and incidentals
- Plant and Equipment
- Building Allowances
The Income (what you receive):
- Rental Income
- Tax credits
Put simply, if your costs exceed your income, it equates to an investment property that is operating at a loss. This opens the door to Tax Effective Geared Investing.
Depreciation and its tax benefits for investors
Depreciation is another tax effective benefit of purchasing an investment property because it allows you to effectively claim a compensation or non-cash deduction for wear and tear on your investment property against your taxable income.
There are two types of depreciation allowance available to you as an investor and they include:
- Depreciation on plant and equipment (such as dishwashers, ovens, floor coverings and window treatments) and;
- Depreciation on the Building Allowance which refers to the building cost or the value of the property at the time of purchase.
If your investment property is brand new, you are entitled to claim full depreciation benefits against your taxable income. You can only claim depreciation for up to 40 years, which is why as a property investor you are better off buying a brand new property as you can receive full depreciation benefits.
How can you turn a negative into a positive?
Property investment is big business to the Australian Tax Office (ATO). You’re receiving an income in the way of rent but you also have costs. When these costs are greater than the rental income, the ATO allows you to deduct these losses from your alternative income (such as wages), which then become tax deductible losses.
For example, imagine you earn $75,000 in salary, but lose $12,500 on your investment property. In this case, the ATO will allow that $12,500 to be deducted from your salary, so you only pay tax on $62,500. Your taxable income has been reduced and you have the added advantage of having something to show for your money – an investment property.
This is what we like to call “tax effective geared investing”. It turns a negative into a positive and can provide enormous benefits for investors. That’s why the majority of investment properties in Australia are “tax effectively” geared.
The benefits of tax effective geared investments are immediate.
Although the government provides a tax credit on investment properties, there’s no need to wait until the end of financial year to enjoy the benefits.
Instead, you can complete an Income Tax Withholding Variation which, once approved, will allow your employer to reduce the amount of income tax they withhold, providing you with the cash flow to support your investment property. This will make owning an investment property from day one easier.