Those promoting the strategy often highlight the tax credits that are available for the would be property investor who owns and rents out the loss making property, claiming that “The tax man and your tenant will help you pay off your mortgage”.
In this article, I’m going to answer the question “What is negative gearing?” by explaining how negative gearing works and providing an example of the pre-tax and after-tax losses, so that if you’re thinking about investing in property, you’ll understand why this investment strategy may not be suited for your goals.
If you’re looking at investing in property, then you’ve probably seen plenty of advertisements from developers and other companies that claim that by using the equity in an established family home as a deposit, $50 a week is all it takes to own your own investment property. What’s more, their staff will manage the whole process for you, from locating and acquiring a property through to locating tenants and managing the property.
Now, there’s one part of this deal that is glossed over, and that is the where and how you will locate the funds required to pay for this loss making property – because it means you’re going to have to either earn more, save less or spend less. Using their quoted $50 a week figure, that’s $2,600 per annum – and this figure could blow out quite easily if they are unable to locate a tenant to rent the property immediately.
How does Negative Gearing Work?
However, let’s explore the “tax benefits” from a negatively geared investment property a little closer with an example, and you’ll begin to understand why I don’t like negative gearing.
I’m going to assume that you’re earning an average wage/salary from your job (ie in the $37,000-$80,000 per annum bracket).
For every $100 that you earn from your job, the ATO will take $31.50, leaving you with $68.50 that you can spend, save or invest.
Now, with negative gearing (or any other tax deductions), the equation works in the reverse – for every $100 that you spend on the property, such as on the interest on the loan, council rates, water rates, property management fees, it will reduce your tax liability by that amount and you’ll get $31.50 back.
Negative Gearing Example:
To explain this a little better, I’ll use a quick scenario. Let’s assume that you decide to purchase a $400,000 home as an investment property – an average 3 or 4 bedroom home that is in a reasonable suburb of Adelaide – perhaps it’s in the same suburb you live in, or a neighbouring suburb. After all, that’s where the majority of first time investors will be looking to buy.
With a typical 90% mortgage, you’ll need to provide a $40,000 deposit to purchase this property, plus closing costs for the transaction (Stamp Duty, Transfer Fees, etc) which will cost just over $20,000 by the time you pay your conveyancer.
In this scenario, I’ve based the calculations on borrowing 90% of the property with the 10% deposit being funded from cash, however it may be possible to borrow against the equity in your current home to use as a deposit.
Interest rates are very low at the time of writing this article, so you should be able to borrow the funds to purchase this property at about 5.79% variable rate, or possibly even lower if you agree to a fixed rate loan. Let’s see how this plays out in the table below.
|Rental Income ($390/wk)||$20,280.00|
|Management Expenses (7.7% of rent)||$1,561.56|
|Interest Expense (5.79% pa)||$20,844.00|
|Tax Credits from ATO||$1,614.55|
|Shortfall to be funded (Net Loss)||$3,511.01|
Based on the scenario above, if you owned that negatively geared property, you would need to find $3,511.01 per annum from your household budget to fund the loss ($67.52 per week).
Again, this is assuming zero vacancies in the property.
Now, how many properties can you afford to buy and own if each property that you own is going to require you to find about $3,500 per annum from your budget to offset their losses? One? Two? Perhaps three or four at a stretch, but I’m sure you’d definitely be feeling the pinch on your family’s budget by that point and find yourself questioning why you’re investing in property.
How can you make money from a negatively geared property:
In order to make money from a negatively geared property, the property that you’ve invested in needs to appreciate in value, by more than what you’ve lost in holding costs.
This is easy to achieve while the market is booming, however during a flat or declining market, which is what we’ve been experiencing in Adelaide since 2010, then it really starts to become a questionable investment, forcing you to hold onto the property for longer, hoping for capital growth to offset your accumulating losses.
This then starts to become more about how long an investor can afford to continue bankrolling a loss making property hoping for a successful outcome, which begins to remind me of many casino games, rather than being about holding onto a skillfully selected investment, where the expected return is known before it is purchased.
What is the alternative to negative gearing?
The alternative is purchasing (or creating) a positively geared rental property.
These are properties that will provide you with an additional income stream, as their expenses are lower than the rental income that you can earn from them, meaning that they’ll put money into your pocket every month.
Assuming the reverse of the situation above, where the property is able to provide you with an income of about $3,500 per annum, then how many of these cashflow positive properties can you afford to own? The answer, of course, is an unlimited amount, as each property that you own is going to make you richer, allowing you to purchase more property.
So, why doesn’t everyone invest in cashflow positive property?
Quite simply, because it’s become increasingly hard to locate cashflow positive properties.
For most “buy and hold” property investors that are looking for positive cashflow properties, this means purchasing properties in lower socio-economic areas, or rural and regional areas.
These “less desirable” areas are typically avoided by first time “mum and dad” property investors because they don’t feel comfortable investing in these areas – they are making an emotional decision about their investing.