One of the most popular methods Australians use to reduce income tax is to buy an investment property.
Through a process known as negative gearing, vast numbers of ordinary citizens reduce their annual tax bill and hopefully make capital gains.
As popular as it may be, it is not a strategy that is without risk. Gearing essentially means purchasing using debt. Negative gearing involves funding a purchase with debt, where the interest charges you pay on the loan exceed the rental income you earn on the property. In other words, you incur an annual loss.
That loss is then deducted from your annual income, which then reduces the amount of income tax you have to pay.
While the idea of losing money doesn’t sound appealing, there is a sensible strategy at work here. By reducing your annual income, you can save many thousands of dollars on income tax. Obviously, the more money you earn and the higher the tax rate you pay, the more income tax you will save.
But the real pay-off comes down the track. Over the longer term, Australian real estate values have appreciated at a greater rate than inflation.
That means that potentially, if you play your cards right, you can reduce your income tax each year and end up making money in the process if you sell the property for a price that is higher than you initially paid.
It works like this. Say you’ve bought an investment property for $400,000. You pay around $25,000 in interest on the loan that you used to buy the property. But the rental income you receive is about $15,000. That means you’ve incurred a 10,000 loss before other expenses. That is then deducted from your taxable income.
If you sell that same property for $500,000 you end up with a $100,000 profit. That is considered income and is taxed at your marginal tax rate. If you hold the property for more than one year, only half the capital gain incurs the tax.
That’s the way it works if everything goes according to plan. Obviously if you pay too much for the property or values decline during the period you own it, you could end up with a loss that would far outweigh the tax you’ve saved. Remember, the money you’ve borrowed to buy the property must be repaid.