Negative gearing is a term that has been thrown around by business people and accountants alike for years – but what is it? Is it a good thing and does it still work in the new tax environment?
In a nutshell Negative Gearing is about reducing your tax that you need to pay on your annual tax return, be it a personal or business one.
It has been around for some years, and to date appears to be staying around for time to come.
It is basically where the Australian Taxation Office lets you apply a loss to other income so that your overall income is less and therefore you don’t need to pay as much tax.
There are not many allowable types of losses that the Australian Taxation Office will accept mind you – and we normally use the term negative gearing to apply to rental income – that is where you are renting out a residential home for someone to live in.
To put an explanation behind this ‘logic’ – the Australian Taxation Office allows people to regularly make losses on renting out homes to people as they expect that the rental rates therefore will be kept at a lower weekly rate for the renters than if they were compelled to make a profit each year. It also helps ensure that there are enough houses made available to rent and thus meeting demand. So really its a subtle form of social policy brought in to create a kinder housing community.
To understand a little more – for instance why would one bother with negative gearing – after you all you are deliberately making a LOSS!
The loss is not always a ‘true loss’. You see, it’s all a matter of when you are allowed to claim deductions for different types of expenses.
Classic expenses such as interest on a loan to purchase the rental property, pest control, rates, water, repairs and so on are immediately deductible. The interest portion alone may often be bigger than the rent received from the tenant!!
Other expenses such as renovations and asset purchases (such as a new oven) need to be deducted over time using a system called depreciation. If you have recently purchased a property with the intent to immediately rent it out its often a good idea to contract a quantity surveyor who will give you a thorough listing of all the allowable items that can be expensed this way over time and the calculations of just how much can be deducted each tax year.
So we have all the expenses – and they are much bigger than any rent we can expect to get for the house – what now?
The expectation – rightly or wrongly- is that property prices increase innately every year. Sure its clear that its not ever going to be a standard increase each year, in fact some years the prices can decrease quite sharply, but in a long term investment the returns are often quoted at 10% per annum average.
So the strategy here is this:
You buy a house and rent it out, making an overall loss each year on it. As a result you will have less tax to pay each year this occurs.
When you finally sell, the expectation is that the house will be worth more than when you bought it and thus you make a capital profit. Note that the more aggressive you are with depreciation expenses over the time of ownership, the more likely you will impact the size of capital gain you will need to pay tax on by increasing it at the end.
Its generally expected that all the losses over the years will be overall less than the profit at the end – and you have paid off a house and thus have a good sized nest egg to boot.
Hopefully you can see that negative gearing has innate risks involved with it – that is what if you have a horror tenant? (although you can purchase landlords insurance to help with this) and what if the house you purchased does not increase in value or worse still decreases in value?
However when they work well it can be a great tax strategy to use.
Obviously there are so many versions of negative gearing that can be used but the above is to give you a real feel of just what it is, and how it can affect you.