Getting to grips with negative gearing
As prices rise in many suburbs across the country, negative gearing is back in the media spotlight. Some see this tax policy as a helping hand to investors, encouraging independent wealth creation. Others believe negative gearing causes investors to flood the market and thus acts as a barrier to first home buyers by artificially inflating the cost of housing.
To individual investors, the most important question is whether negative gearing fits within their investment strategy. With the right planning, a negatively geared property can become a positive for the investor’s bottom line.
How negative gearing works
Negative gearing is a tax policy that allows investors to deduct their investment losses from their taxable income.
“Negative gearing is effectively saying that you're running the investment at a loss, and then that loss is offset against the income you earn for that year,” the Property Investment Professionals of Australia (PIPA) chair Ben Kingsley says.
This tax write-off applies to virtually all investments funded by borrowings, AMP chief economist Shane Oliver explains.
“It applies to all aspects of negatively geared investments, whether it be residential property, commercial property, shares, you name it,” he says.
Negative gearing is often used when an investor’s rental returns are insufficient to cover the property’s mortgage repayments.
The investor might collect $10,000 a year in rent, but spend $25,000 on interest, maintenance and other costs. If they earn $100,000 a year, negative gearing would allow them to reduce their taxable income to $85,000, potentially earning them a sizeable tax refund.
This write-off can minimise losses on the investment to a substantial degree, Mr Kingsley says.
Alternatively, he suggests investors apply to the Australian Taxation Office (ATO) for an income variation. This allows investors to forecast losses on the property for the year and reduce the tax payable on their weekly or monthly income.
A number of expenses can be taken into account in calculating the total cost of the property, according to Mr Kingsley, but he says the process isn’t always simple.
Claimable expenses might include property management fees, repairs and maintenance costs and lender’s mortgage insurance in the first five years, he explains. However, due to the complicated regulations involved, Mr Kingsley urges investors to seek professional help when taking this approach.
“The only person you can talk to in regards to tax advice and the tax implications of this matter is a licensed tax agent,” he says.
Negative gearing was introduced into the tax framework to reduce the cost burden of investing, Mr Oliver believes.
“It makes logical sense in that servicing a debt that relates to investment is part of the cost of investing, therefore you should be able to reduce your taxable income by that amount,” he says.
In his view, the policy lowers the expenses associated with investing, thereby encouraging more people to invest.
When people invest in a negatively geared property, they are looking for strong growth in that property.
Benefits of negative gearing
Negative gearing helps investors to hold onto a property that is not immediately generating a profit. But why would investors want an asset that is costing them money?
These investors are betting on large capital growth gains in the future, Mr Oliver says.
“You hope that the value of the building rises such that when you sell it, in say five or 10 years, the capital gain offsets all the losses made,” he says.
Mr Kingsley suggests buyers who choose the right property in a high growth area could stand to profit from negative gearing.
“When people invest in a negatively geared property, they are looking for strong growth in that property,” he says.
In many cases, properties with high capital growth prospects tend to have lower rental yields and vice versa, he explains.
“Statistical evidence will show us that the properties where the value of the asset is higher, the rent differential is lower,” Mr Kingsley says.
In addition, most negatively geared properties do begin generating a profit further down the line.
“It eventually does become cash flow positive,” Mr Kingsley says. “There are not too many properties in the history of Australia that wouldn't have gone positive over a period of time.”
This change happens as the loan is paid off because the value of the property grows while the debt decreases. In addition, Mr Kingsley explains, owners generally have the ability to charge higher rent as the property becomes more valuable.
“Now, if you're paying that property down over time and the rent is going up, your overall cash flow position then becomes positive,” Mr Kingsley says.
At that point, the property starts delivering a passive income to the owner and ceases being negatively geared.
Drawbacks of negative gearing
While some investors are enthusiastic in their support for this policy, others are more sceptical.
Founder of Smart Property Adviser Kevin Lee believes negative gearing is nothing more than “supporting your tenants’ lifestyles”.
“If an investment is taking money out of your property every month, that's not a good investment,” he says.
Mr Oliver urges investors to be cautious when taking this approach.
“There is always a danger in letting a tax strategy drive an investment,” Mr Oliver says.
“Before making any investment, you should make sure it stacks up on its own without the tax advantages.”
Mr Kingsley believes anyone who buys a property purely to gain a tax advantage is “crazy”.
“The actual asset itself and the investment are still running at a significant loss,” he says.
If investors choose their assets poorly and simply rely on negative gearing, they will be in a dangerous position, according to Mr Kingsley. The property needs to meet fundamental investment criteria so it will experience capital growth and ultimately offset the previous losses.
He warns that unscrupulous businesses try to sell the benefits of negatively geared properties to ‘mum and dad’ investors in locations that are unlikely to see high capital growth.
Mr Lee, however, doubts that any area offers a strong growth proposition. In his experience, there is no guarantee any property will appreciate in value.
“People have been told for 40 years in Australia that properties double in value every seven to 10 years, but really it depends on a thousand different variables,” he says.
He argues that people buying negatively geared property are unlikely to see a profit, particularly given Australia’s current demographic trends.
Around 5.4 million baby boomers are set to retire in the next nine years. Given that people in this generation are the major drivers of property market activity, this departure is likely to stop capital gains in its tracks, Mr Lee believes.
He urges his clients to focus on high cash flow rather than capital growth in their investment strategies.
Indeed, cash flow constraints are another major drawback of negative gearing.
“It is going to require surplus cash flow in your household budget, so you've got to make up that shortfall,” Mr Kingsley says.
Investors need to consider their future needs as well as their current expenses, he suggests. Major life changes could force investors to sell their property before any capital gains have been achieved.
“For the first several years, the property is going to be running at a loss and they need to support that loss with their own income. If they can’t do that, they could be caught out significantly,” Mr Kingsley says.
Moreover, a portfolio heavily weighted towards negatively geared properties could leave people with too much debt and limited income in retirement, he warns.
According to Mr Lee, negatively geared properties can prevent a portfolio from growing quickly.
“If that $1,000 a month to fund the property is coming out of your cash flow and you have $4,000 in your after tax income, how many properties can you afford to buy until you start to bleed?” Mr Lee asks.
Ultimately, Mr Kingsley advocates holding a mixture of properties.
“You want a situation where you've got good growth properties mixed in with a good bit of yield, so you have a nicely diversified portfolio that's going to give you both growth and really strong income in retirement,” he says.
The property is going to be running at a loss and they need to support that loss with their own income.
A viable policy?
With reports of first home buyer numbers hitting record lows, the far-reaching effects of negative gearing are coming under increased scrutiny.
“There is an argument that it does benefit investors, and more investors tend to push up the value of property generally, which also benefits existing homeowners. All of this has the effect of pushing out the first home buyer,” Mr Oliver says.
However, he believes this argument is misguided.
“Were it not for the investor, we would not be going through the construction boom that looks like it's now underway in the property market. As a result, it would be even worse for buyers of their first property,” he says.
Mr Oliver sees an undersupply of property as the fundamental issue keeping prices high.
“The basic point is that we're not building enough houses,” he says.
While Mr Lee does not believe negative gearing is a sound investment approach, he thinks removing the tax break would do more harm than good because changing legislation tends to have knock-on effects that cost time and money to rectify.
Finally, Mr Kingsley thinks investors do “a lot of the heavy lifting that the government can’t do”.
“Thirty per cent of the population rely on rental accommodation. If that accommodation isn't being supplied by these ‘mum and dad’ investors, then the government is going to have a multi-million dollar burden in terms of providing public housing for these people,” Mr Kingsley says.
Investor profile
Julian Cofield
Currently, we have two properties that we own; our principal place of residence in Ballarat and a three-bedroom townhouse investment, which is also negatively geared. We’re also in the process of purchasing a house and land package in Queensland.
I bought my first property – a small unit in Lara in Victoria – in 1998 with $5,000. My parents had three or four properties and their approach was all about negative gearing. Up until May last year, I thought negative gearing was the way to go too. Then I got involved with a property mentor and it opened my eyes to positively geared properties.
I have just turned 40 and I don’t want to keep working through to 50; I’d like to be able to retire early. The cash flow and equity gains available with the right properties paying an income is the way we’re going to be able to obtain our financial freedom.
Experts divided
Property pundits and politicians are divided about the potential consequences of abolishing negative gearing. In 1985, the Hawke/Keating government altered the country’s negative gearing policy – a move which some say caused rents to spike. Others argue the policy needlessly cost the government billions in lost tax revenue.
Investor incomes
Taxpayers with incomes between $37,000 and $80,000 claim the most under negative gearing, according to the Grattan Institute. Those with incomes under $20,000 per year made losses totalling over $2 billion in the 2010/2011 financial year.