By Andrea Bradley
What is negative gearing and how does it work?
An investment is considered to be negatively geared if it is purchased with the assistance of borrowed funds, and the net income is less than the interest incurred on the borrowings. In other words, there is an economic loss from the investment because the various holding costs (including interest costs) exceed the income earned.
An investment is considered to be positively geared where the net income exceeds the interest on borrowings. In other words, there is an economic profit from the investment as the income is greater than the holding costs. Tax must be paid on this profit.
Whilst negative gearing is most commonly associated with investing in real estate, its application can also extend to other income-producing assets (e.g. listed shares).
What are the tax benefits?
Where an investment is negatively geared a taxpayer can reduce their taxable income to the extent that they have incurred a loss from their investment. The consequential reduction to their tax liability will partially offset the economic loss. For example a taxpayer who is taxed at the top marginal tax rate and has made a rental property loss of $10,000 will receive a tax benefit of $4,900 at year end, thereby reducing the loss to $5,100.
For the tax benefits of negative gearing to work, you must have other income from which to claim the tax benefit. The size of the tax benefit depends on the personal marginal tax rate of the investor. This benefit can vary from nil through to 49%.
In principle, a negatively geared investor who is taxed at the top marginal rate will obtain a larger tax benefit compared to an investor who is on a lower income. The opposite can be said however where the investment is positively geared. Over time this occurs as the investment moves from being negatively geared to being positively geared.
Prior to 1 July 2009 the reduction in taxable income due to negatively geared investment losses also resulted in other benefits. However from 1 July 2009 tax offsets, levies, child support and Centrelink payments now take into account negatively geared investment losses. A taxpayer is required to add back any net investment loss to their taxable income for these purposes.
Should you consider negatively gearing as a tax strategy?
Whilst negative gearing may provide some upfront tax benefits it does not necessarily guarantee that over the long term the investment property will provide an overall economic gain. From an economic viewpoint a negatively geared investment will only be of benefit to an investor if the capital growth from the investment exceeds the sum of any net ‘after tax’ losses generated during the ownership period. In this regard an astute investor would seek to maximise their investment by deriving an economic profit as soon as possible (albeit any net investment income will be taxable).
Borrowing funds will increase the amount you can have invested. This has the potential to increase gains because there is more of a capital base on which to earn returns but the reverse can happen and losses can be magnified. A gearing strategy can help build wealth but the risks need to be understood.
The ability to negatively gear needs to be kept in perspective as an aid to investment and not a goal in itself. The strategy is sound as long as the investment is also sound, and will over the long term give you a positive return. A good investment must eventually show a profit, and its merit should always be judged on its expected returns and not on any short term tax benefits.
The above outlines the arrangements relating to negative gearing as they currently exist. There is discussion that the rules relating to negatively gearing, specifically in relation to rental properties, may change in the future. It is always important to seek advice before deciding to proceed with a negative gearing arrangement. Please don’t hesitate to contact us if you have any questions.