Negative Gearing is one of the major drawcards to investing in property, but how does it work?
What is negative gearing?
An investment property is negatively geared when the return, or rental income, is less than the property’s expenses. This essentially means that the investment property is making a loss.
The loss from a negatively geared property is deducted from the investor’s taxable income, reducing the tax that has to be paid.
Benefits of negatively geared property
But why would you deliberately make a loss? Everyone’s financial situation is different, however, there are two key benefits of negative gearing.
1. Long-term capital gain.
Many investors hold onto their properties as part of a long-term wealth creation strategy. Their aim is to sell them in later years at a profit as the property market grows, or to use the property to fund their retirement. Hopefully the capital gain in the long term far exceeds the loss in the short term. In any case, only 50% of capital gains are taxed, while 100% of rental losses are tax deductible now.
2. Reduction to taxable income.
Property is a tangible asset and if it’s making a loss, it reduces the investor’s taxable income and they pay less tax. This can prove to be beneficial in the short-term and early stages of growing a portfolio.
How does Depreciation help?
Property depreciation is the natural wear and tear of a building’s structure and assets. Property investors can claim this as a tax deduction each financial year. A big bonus with depreciation is that it’s a non-cash deduction, so investors don’t need to spend any money to claim it.
Depreciation can be claimed under two categories. The first being capital works deductions on the structural component such as walls, windows and sinks. The second category is plant and equipment deductions on the easily removable assets like carpet, ceiling fans and hot water systems. From 1 July 2017, you cannot claim a deduction for depreciation on second-hand plant and equipment already in your residential rental property when you purchased it. However, you can claim depreciation when you replace any plant and equipment.
The two broad categories mean that investors can claim depreciation on almost anything they buy for the property.
Depreciation and Negative Gearing
Given that depreciation is a non-cash deduction, it can turn a cash-positive geared property into a negatively geared one for tax purposes, without making any cash loss. Let’s see how this works.
Kerry earns $80,000 a year. As well, Kerry receives $25,000 in rental income. Her property’s tax deductible expenses include interest repayments, maintenance costs, insurance, council rates and property management fees that come to $22,000 for the financial year. Her property is cash-positive with a $3,000 cash return. Kerry’s tax bill is about $18,500.
By claiming depreciation, Kerry can make capital works and plant and equipment deductions totalling $6,000 for the financial year. This changes the previously cash-positive property to be negatively geared, with a $3,000 loss for tax purposes.
For no additional cash outlay, by claiming depreciation Kerry’s tax liability decreases to approximately $16,500, saving her $2,000 in tax.
May Klye and Associates specialise in advising property investors on maximising their return from their property portfolio, whether it’s through structuring advice or the claiming of all legitimate expenses. If you need some advice, call us on 03 9585 7555 or email firstname.lastname@example.org