Negative Gearing is a term that most people associate with Investment Property, but can equally apply to Shares and many types of investments.
The basic idea with negative gearing is that a person borrows money to buy an asset, and the income from the asset is less than the costs of holding that asset.
What it means for Investment Properties
In the case of Investment Property, this would mean that the Rent received on the property would be less than the Interest on Borrowings, Management Fees, Body Corporate fees or Rates & Utilities, Depreciation and many other holding costs.
The shortfall (loss) for the year would be offset against the investor’s other income, typically wages, and a tax refund would ensue. The higher the income (and hence marginal tax rate), the greater the tax benefit of being negatively geared.
Of course you must remember that you need to be making a loss first before you get some of it back by way of tax refund, so you’re still making a loss overall.
So why would you knowingly enter into such an arrangement, given that it’s going to cost you money to start off with?
The obvious answer is that you are hoping to sell the asset eventually for a lot more than you paid for it. The difference between the net selling price and the gross costs of buying is your “Capital Gain” which itself is taxable but is subject to certain tax concessions.
The investor’s hope is that the net capital gain achieved after taxes is greater than the net shortfalls each year while the asset was held as an investment.
Now we know that in Australia, generally speaking, we’ve enjoyed rising property prices although these rises are certainly uneven from year to year and from one location to another. Property prices in Sydney & Melbourne doubled between 1988 & 1990 after the share market crash, but if you had invested in property in North Queensland mining towns 5-7 years ago, you’d be unfortunately looking at a sizeable fall in values.
Negative gearing is not a quick fix for reducing tax
The bottom line is that Negative Gearing is not an arrangement that should be entered into just to reduce your taxes. You need to have an eye on the bigger picture and be reasonably confident that the capital gain you expect is achievable and will compensate for the shortfalls.
In order to work out whether you will be better off, there are many variables that need to be taken into account. These include, but are not limited to:-
- Buying & Selling costs, including Stamp Duties, legal and agent costs
- Capital appreciation rate over the holding period
- The actual expected holding period
- The costs of holding now and in the future
- The opportunity cost of your initial investment (deposit)
- The rate of inflation expected
- Rental rates expected over the holding period
- Costs of Repairs & Maintenance in years to come
- Expected shortfall over coming years
- Depreciation allowed and impact on Capital Gain calculations
- The investor’s expected salary income & marginal tax rates.
It should be emphasised that the biggest factor is the value of the property at sale time. As we seem to have entered a prolonged period of low inflation & low interest rates, it would not be surprising if property values did not increase at the same average high rates that have historically applied.
What about negative gearing against (say) a portfolio of blue chip shares?
The first difference is that you can’t gear to the same level as property. Most lenders will only lend to 50% of the value (unless additional property security is offered), and you may be subject to margin calls if share prices fall.
Your income will consist of dividends, some of which may be franked, thus giving you additional tax advantages. Holding costs however are negligible and this is a major difference to holding property. Another advantage is that shares are very “liquid” and able to be sold at very short notice and at minimal brokerage cost.
Of course shares are somewhat more volatile than property and you could end up with a holding shortfall as well as a Capital Loss if share prices fall and you decide to sell. It is more prudent when it comes to share investment, that you take a longer term perspective.
Let us help you
At John R D Tate & Partners we can assist in working out financial projections based on various scenarios for your proposed investment. We can answer the question “If I buy an investment property now for (say) $500,000 borrow $450,000 @4.5% and rent it out for $500 a week, how much would I need to sell the property for in 5, 7 or 10 years to come out ahead?” We can answer this question because we understand all the tax implications and take all the relevant factors into account.
If you’re contemplating negative gearing into property or shares, please talk to us as this will assist in your decision making process. Please feel free to call us on 07 3715 8711 to arrange an initial meeting with either myself or John Tate.
Newman Borg is a Partner at John R D Tate & Partners
This article is intended as General Advice. You should consult an appropriately qualified professional for any major investment decisions.