Profiting from loss
In a rising property market, negative gearing can be a good strategy to build wealth but watch out when values fall, writes Bina Brown.
In a rising property market, negative gearing can be a good strategy to build wealth but watch out when values fall, writes Bina Brown. There are plenty of reasons why Australians love to borrow money to invest in bricks and mortar.Some people think the value of property never goes down others like the fact you can see and touch it.But, mostly, it is the ability to offset the cost of owning the property - including the interest paid on a loan - against assessable income that makes it particularly attractive.As long as the loan costs are greater than the rental income, then the Australian Taxation Office allows investors to offset the loss against their income.This strategy, known as negative gearing, is often considered more a tax strategy than an investment one.Since the aim of most investment strategies is to make a profit, investors with negatively geared property either hope that one day the rent covers the loan costs or the capital growth in the property is such that they make a profit when it comes time to sell.As soon as the rent covers the cost of borrowing, it becomes a positively geared property and the income might be subject to tax. Many, however, would say it is better to pay tax on a profit than make a loss.For most of the 30-or-so years negative gearing has been around, it has been a reasonable strategy based on the capital growth rates of property across the country, says the founder of Smart Property Adviser, Kevin Lee.However, at a time of global economic uncertainty, betting on capital gains from property is a risky and outdated strategy for most people, he says.Lee would rather see people save more for a deposit on a property that can then be rented for more than the weekly outlay. If it generates a capital gain, then that is a bonus."If you are investing for income, and the income is paying for the property, then you are a savvy investor," he says. "But there are no guarantees for capital growth."An accountant and the founder of Mr Taxman, Adrian Raftery, also warns against anyone investing in property simply for a tax deduction."The only upside is that you are reliant on the property increasing in capital growth by an amount greater than your outlay - but remember to factor in capital gains tax and what you could have received if you simply had your money in the bank on term deposit," he says."If a property market is stagnant - like we are experiencing in Australia - then you will be falling behind. If the property market falls like it has around the world, then you are in a dire situation."The chief executive of Resi Mortgage Corporation, Lisa Montgomery, agrees too much emphasis is on the tax advantages of negatively geared real estate and not enough is on creating real equity in the property.Ideally, the property investment strategy of borrowers should focus on creating equity by accelerating payments to reduce their loan.That equity can then be used to buy additional properties - for which the rent covers the costs of holding the property - if that is part of the financial plan.The right wayNegative gearing property has supporters and opponents. The tax benefits are an incentive for people to borrow to buy property with a view to making themselves more financially independent in retirement.For someone with little in the way of a deposit, the tax deductions make it possible to borrow most of the cost of a property, then rent it to pay most of the interest and other costs (see the case study, above right).But the strategy's success or failure ultimately comes down to the property and the rent it brings in. A mortgage broker with Loan Market and a property investment consultant with NPA Property Group, Adam Zahra, says negative gearing is beneficial only when the total return on the investment - the capital growth and the yield - is greater than the total cost."It is pointless to purchase an investment for tax savings if it doesn't provide you with a return," he says.Yet this is exactly what thousands of investors are doing, Lee says."Lots of people have done well out of capital growth but lots of other people have not," he says. "In most cases, negative gearing a property is supporting the lifestyle of the tenants."If the rent paid by a tenant is not enough to support the cost of owning the property, then people are doing it in the hope that capital gains will come as a right."A neutral or positively geared property means the tenant is paying the true cost of living in that property.Zahra says good research makes it possible to buy property that can be reasonably expected to increase in value and bring in sufficient rent, coupled with depreciation, to almost cover costs.Depending on the deposit paid and whether there are sufficient capital works allowances and fixtures and fittings in the property that can be depreciated, it is possible to go from having a net rental loss to being cash-flow positive.Zahra says the best position is to be negatively geared but cash-flow positive. The way to do this is to take full advantage of the tax-deductible depreciation allowances laid out by the Tax Office.The newer a property, the greater the depreciation levels. Construction costs can be depreciated at 2.5 per cent over 40 years.The rate of depreciation varies for fixtures and fittings.The tax deduction from depreciation, known as a non-cash loss, and the difference between the income and expenses (the cash loss) can result in a positive cash flow from the ATO (see story, left).It is important to obtain a depreciation schedule prepared by a quantity surveyor to maximise relevant tax deductions. Zahra says the cost of holding an investment property can be very tax-effective, especially for high-income earners. It is possible to get the tax back on a regular basis rather than the end of the year by using a tax-variation authority (formerly known as a 221D). This can significantly reduce the cost of holding the investment property.Lisa Montgomery of Resi says that even with the tax advantages of negative gearing, it won't suit all investors."There is always some risk associated with borrowing to fund an investment," she says. "If you overextend your borrowing, rising interest rates could restrict your ability to meet the loan payments."Montgomery says investors should minimise the risk of gearing by choosing an investment property that is likely to increase in value throughout the investment period."Your pre-buying research is the key to choosing the property wisely in the first place," she says. "You should also have sufficient income to cover your costs if your tenants are late with their rent, or if your property remains vacant for any period of time. You also need to be able to fund ongoing repairs and maintenance."As a general rule, only investors with the financial capacity to absorb the effect of potential falls in property values, as well as an increase in interest payments, should consider negative gearing."Tax treatment of negative gearingInterest on an investment loan for an income-producing purpose is fully deductible. Any shortfall is offset in an individual's taxable income, which includes the rent they receive from the property as well as any salary.Ongoing repairs and maintenance and small expenses are fully deductible.Property fixtures and fittings are treated as plant and a deduction for depreciation is allowed, based on effective life.Capital works (buildings or major additions constructed after 1987 or certain other dates) receive a 2.5 per cent-a-year capital works deduction (or 4 per cent in certain circumstances). The percentage is on the initial cost (or an estimate) until exhausted. The investor's cost base for capital gains tax purposes is reduced by the amount claimed.On sale, capital gains tax is payable on the proceeds, less some costs. A net capital gain is taxed as income but if the asset was held for one year or more, the gain is first discounted by 50 per cent for an individual.How it worksThere are two types of costs associated with owning an investment property.Cash costs include interest payments, bank fees, maintenance costs, insurance premiums and property management fees.The other type is depreciation, which is a non-cash cost. If you add the amount of cash and non-cash costs and they exceed the rental income, then there is a net rental loss which may be able to be claimed against your other taxable income, such as your salary.A typical example might result in $27,000in cash costs and $20,000 in rental income. This would mean that the tax benefitbased on the $7000 net rental loss would be as below.We can also see that if the property was new and had approximately $8000 in depreciation (typical value) then this can alter the cash flow, as below.What the table shows is that negative gearing is more beneficial to people in the higher income brackets who pay tax at the top marginal rate.In the above example, the taxpayer on the highest tax bracket gets a tax refund of $3255 and would be out of pocket $3745. But if they were in the lowest tax bracket they would only get $1155 back and be out of pocket by $5845.If depreciation is accounted for, then the cash outlay for a person in the highest tax bracket could be $25 a year. For a person paying 16.5 per cent tax, the cash outlay would be $4525 a year.The ATO publishes a rental property guide, which includes how to treat rental income and expenses, including how to treat more than 230 residential property items. It also provides a guide to what can be depreciated at what rate.Investment makes senseWITH a high taxable income and a home almost paid off, it made sense for Victorian-based insurance agent Aaron Donaldson and his wife Sarah Pike to negatively gear an investment property.With the help of NPA Property Group and having done their research they settled on taking out an investment loan to buy land and build a four-bedroom house in Toowoomba, Queensland, which they would rent out.Aaron maximised his negative gearing by borrowing the entire purchase price and transaction costs. "It made more sense to leave any deposit in our offset account and use this to reduce our interest on loans which we couldn't claim the negative gearing benefit on," Aaron says. "Being a new property, we saved on the stamp duty and the depreciation value is much higher than an existing property."They had the added bonus of being able to do a tax variation and claim a tax deduction from the ATO immediately, without waiting until they filed their end-of-year tax return.The property cost $370,000 all up for the land and construction and it was recently valued at $420,000. The tenants moved in on December 2 and are paying $380 a week rent."With the right advice we got some capital growth before we even started renting it and the tax deduction we got up front will almost cover the gap between the rent and the mortgage payments," Aaron says.The couple can now use the costs of the property, including loan interest, depreciation, repairs and maintenance, to offset their taxable incomes.