There’s a lot of discussion taking place about negative gearing and its impact on house prices lately. I’ve read the opinions of a few journo’s and occasionally I’ve had to ask whether the author actually understands the concept of negative gearing or not. So here it is, a beginner’s guide to negative gearing:
Negative gearing is the process of buying an asset (a house) that will initially make a loss (more expenses related to the asset than income from the asset). The investor is speculating that the value of the house will, over time, significantly outweigh the annual loss. The investor also hopes that the interest, rates and fees will fall over time while rent income will rise.
Point 1 – Only your taxable income is taxable.
Taxable income is the amount of income you actually have to pay tax on. In simple terms it is your actual income less any deductible expenses. Deductible expenses are usually the expenses incurred in earning your income in the first place. For example, if you are self-employed and you have a business phone, then those phone expenses will be deductible as it was required to earn some portion of your income. In the case of an investment property, the costs of the investment property (interest, fees etc.) are deductible against your income.
Point 2 – Deductible expenses decrease your taxable income
By a fairly logical extension of point 1, if you increase your deductible expenses you decrease your taxable income and therefore the amount of tax you pay overall. Again, in the case of property, if you buy an investment property and the overall costs of the property are higher than the rental income you receive you will have a net loss. This net loss will decrease the amount of tax you pay.
Income from work: $80,000 (tax of $19,100)
Income from property: +$15,000
Expenses of property: -$20,000
Taxable income: $75,000 (tax of $17,400)
Point 3 – Negative gearing costs you money in the short term
As seen above, negative gearing costs you money each year. In the above example it cost an additional $5,000 and generated a tax saving of $1,700, a net cost of $3,300.
So why do people do it?
If negative gearing costs you money out of pocket each year, why do it? The advantage of negative gearing is that, for a net cost $3,300pa, an investor has gained control/ownership of a $500,000 asset. If this asset value goes up by just 2% a year, that’s a capital gain of $10,000 – easily accounting for the short term loss of $3,300. On the other hand, if the asset drops by 2% in a year, your $3,300 loss just became $13,300. It works both ways.
In addition to this, the assumption is that rental income will go up over time. Therefore by year 4 or 5, the rental income has now met the costs of owning the property and no further losses will be incurred.
Point 4 – Investment properties are subject to capital gains tax.
When you sell your primary residence you don’t have to pay any capital gains tax. When you sell an investment property you are subject to the full amount of capital gains tax. In the above example, a property sold after year 1 would make $6,700, which is then taxed at the investors marginal tax rate (somewhere around 35-40%). As with most investments you should receive the 50% capital gains discount, meaning only half of the $6,700 would be assessable as it was held for more than 1 year.
Why are some people against it?
Negative gearing encourages people to invest in property. As more and more people invest in property, the prices go up and the low income and first home buyer struggle to break in to the market. The truth is, it can be cheaper to buy an investment property and rent somewhere, than to own your own home and live in it. Weird.
Why do the laws allow it?
Negative gearing is a by-product. The laws aren’t set up to encourage people to negative gear, they’re set up to encourage investors. The tax laws that allow the cost of an investment property to offset the income of that property apply to all forms of investing – shares, business, bonds etc. These laws encourage people to invest and buy into the business they work in or to buy a new business because the cost of borrowing and holding those assets can be offset against the income earned from that asset.
Investment is the lifeblood of an economy. The economy grows because people invest, they buy new machinery, new businesses, new property and everyone benefits through jobs, incomes and even tax revenue (which in theory creates government spending). The challenge for our government is to work out a way to encourage investment without crushing the little guys.