Gearing refers to the process of using borrowed money to purchase an investment property with the hopes of recovering the amount through capital gains, either in the form of rental income or other income earned on the property.
While positive gearing means the income you gain from rental payments is more than the interest payments. In contrast, negative gearing is an investment where the rental return is lower than the cost of property management fees.
Approximately 70% of property owners in Australia with negatively geared assets, showed a taxable income of less than $80,000 a year.
If you’re a property investor or want to become one, you should understand the benefits of negative gearing, associated risks, and the tax considerations that come with it.
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How Does Negative Gearing Work?
In layman’s terms, a negatively geared property has a rental return that is less than interest payments and other property-related costs.
Let’s say you own a negatively geared property in NSW, Australia. The rental property generates an income of $25,000 each year. Combining the cost of holding the property and mortgage interest, your annual expense is a total of $30,000.
Your taxable loss is a total of $5,000, which you can use to reduce the tax payable on your net salary. This only works when you forecast a loss over the financial year. To address the loss, you can apply to the Australia Tax Office and have the amount deducted from your wages.
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Who should invest in negative gearing?
Negative gearing is mostly beneficial for individuals who are earning high income and are in a larger tax bracket, which allows them to reap tax benefits.
Investors should have a reliable cash flow to cover personal income tax, pre-tax costs or earn enough income to cover loan repayments.
When you’re dealing with negative gearing investment properties, always get expert financial advice and identify the right approach that helps maximise net profits.
Can you benefit from owning negatively geared assets?
Yes, there are ways in which you can reduce your tax return in negative gearing.
The Australia Tax Office allows property owners to deduct their rental losses from taxable income, just the same way a business owner would add other sources of income to their net business income.
Additionally, when you sell the property, you are taxed at half the rate, because of capital gains tax discount. Both processes will help determine the total taxable income at the end of the year.
Claim rental expenses as a tax deduction
In Australia, your net rental loss during the financial year can be offset against other sources of income you earn, such as a salary. This helps reduce the taxable income and affects the final tax you have to pay.
Normally you can claim the interest expenses of your loan repayments and other property management fees (such as repair and maintenance) as tax deductions. But this is only applicable when the negatively geared property:
- Is already occupied by tenants
- Is available for rent all year round
Capital gains tax discount and how it affects a tax bill
Just like you pay tax on a rental income, you also need to pay tax after selling a negatively geared property. Once you do, the profit generated in the sale is known as capital gain, and the tax levied is referred to as capital gains tax.
The amount of capital gains tax you pay depends on several factors. If your ownership is more than a year, you become eligible for a discount on CGT. In this case, the tax deductions are lowered significantly, helping you earn more profits.
What are the potential risks associated with negative gearing?
While negative gearing may provide certain benefits, it comes with its own set of pitfalls and downsides. Besides recording a loss of income, negative gearing poses certain risks to potential investors, such as:
- Inability to find tenants who can occupy your rental property at any stage
- Concession offered during a real estate transfer that reduces property value
- Mortgage loans with a high interest rate compared to what you calculated
If you’re not confident about dealing with any more rental losses or high interest rates, get in touch with an expert financial adviser. Such professionals can help you manage such losses on a geared property.
How can you reduce the risk of negative gearing?
Choosing the right investment property
To avoid negative gearing, it’s important to understand the purpose and type of property you want to invest in. Buying a property that’s close to major amenities will appeal to a large number of audiences (prospective tenants). This ensures your property won’t remain vacant for too long.
Managing your income
Property management fees are not always easy to cover, especially when you’re suffering from any income losses. It can cost you a significant amount when the property is vacant or undergoing repairs after being vacant for too long.
Before deciding on negative gearing, make sure you have enough capital to cover any expenses that come with owning an investment property, and continue doing so.
Investing in property insurance
An investment property is an income-producing asset, regardless of whether it’s negatively or positively geared.
It is critical to adequately secure and protect your investment property the moment you buy it. This is necessary in the event of unforeseen circumstances, such as property damage, rental loss, or any other liability costs.
You can also consult a financial advisor to learn more about landlord property insurance.
Key Takeaways
- Negative gearing occurs when rental income is less than the property's expenses, leading to a taxable loss.
- It's beneficial for high-income earners seeking tax advantages.
- The Australian Tax Office allows deduction of rental losses from taxable income, potentially reducing overall tax payable.
- Capital gains tax discounts apply for properties held over a year, reducing tax on profits from property sales.
- Risks include potential vacancy, real estate market downturns, and high interest rates.
- Strategies to mitigate negative gearing risks include choosing well-located properties and ensuring adequate financial reserves.
How to Protect Your Property Investment?
The tax implications for a negatively geared investment property are high, especially if you don’t have the capital or the resources to reap a tax benefit.
Before deciding on which gearing strategy works best for you, speak to a tax consultant or property expert for a quick assessment.
Our Property Investment Services team can offer independent advice and guidance on the above, ensuring the right conversations take place with an accountant and property expert so you can make an informed decision. Get in touch with our Investment Services team today.
