How does negative gearing work?
One of the most often misunderstood concepts is how negative gearing works.
‘A well-chosen property can deliver future wealth – not only from capital growth but also from rental returns.’
Most investors use some form of gearing against a mortgage to fund their rental property dream.
And that’s where the property buzz word, ‘negative gearing’, often comes in.
Put simply, negative gearing in the case of a property means borrowing to invest. The property is negatively geared when income from the investment is less than expenses. That is, the rental income received is less than the loan interest and other expenses being paid out. That’s how negative gearing works.
The benefit of this strategy is that you can adjust expenses to influence gearing by either borrowing more or less, therefore paying more or less interest. Because loan interest is a major expense, negative gearing can assist with the ongoing cost of maintaining the investment — because a loss can also be used to reduce taxable income.
How negative gearing works – an example
For example, you buy a property which brings in $25,000 in rent each year. The cost of holding it, including mortgage interest, is $35,000. You use the taxable loss ($10,000) to reduce your personal income and therefore also reduce the amount of tax payable on your salary.
Another benefit of negative gearing is being able to claim this loss throughout the year, which means you can increase your cash-flow. To do this, you need to apply to the Tax Office to reduce the amount of tax taken out of your weekly, or fortnightly pay. An Income Tax Withholding Variation allows you to make substantial tax savings and refunds sooner, rather than later when you lodge your annual tax return. And it is this strategy that can provide the biggest financial boost to build up a property portfolio.
By lodging a weekly, or fortnightly, tax variation with the ATO, you increase your take home salary, releasing potential funds to cover investment costs, such as owners corporation fees or rates. A perfect example of how negative gearing works in practice and provides a cash-flow benefit.
Moreover, it is important to know what expenses can be claimed as a tax deduction when a property is leased. For example, you can claim borrowing costs; landlord and building insurance; agent’s fees and commissions; repairs and maintenance costs; interest on the investment loan plus other bank fees; gardening; pest control and even cleaning costs.
You can increase your tax benefits by selecting a property to obtain maximum non-cash deductions, like depreciation. Depreciation spreads the cost of an asset over multiple years. It’s set up using a Tax Depreciation Schedule — a report outlining the depreciation of assets in the investment property, such as appliances and fixtures, that can also be claimed.
Negative gearing only benefits you in the long run if the money from the capital growth is greater than the overall loss in the rental shortfall.
It may seem counter-intuitive to be making a loss. But the end game is to make that up with a capital gain as the value of the property increases.
Given gearing can play a significant role your investment strategy, getting expert financial advice is key. Particularly if you need help identifying the right approach to maximise profits.
For a much more technical explanation, the Treasury publish a white paper on negative gearing too.
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