With negative gearing strategies coming under the political spotlight, we thought it might be a good time to provide a refresher on what it all actually means.
So what is it?
Negative gearing is the process of reducing your assessable income with investment losses. Income tax is applied against your assessable income. So, by reducing your assessable income with investment losses, you are able to reduce your personal tax obligations. To make this profitable, you hope the capital growth on the investment is sufficient to offset investment losses.
How can negative gearing build wealth if it involves running investment losses?
The key to negative gearing success is in the disparity in how tax is applied to investment income vs investment capital gains. At present 100% of any investment gains/losses are added/subtracted from your assessable income each year. However, investment capital gains are only taxed upon investment sale, and, if the investment is held for greater than 12 months, then you receive a 50% concession on the capital gain tax.
I.e. As you can deduct 100% of investment losses and pay tax on only half the capital gain, investments that provide low or negative incomes but high capital growth can become structurally advantageous. This deferment of capital gains until time of sale and then its concessional treatment (when held for greater than 12 months) is what makes negative gearing effective.
Key factors in negative gearing
1. Negative gearing requires running an investment at a loss
2. Its effectiveness as a strategy is proportionate to your marginal tax rate (MTR). The higher your MTR, the more tax effective the reduction in your assessable income will be
3. Negative gearing is only effective if there is a material capital gain in your investment
4. Negative gearing applies to nearly all investment types; it is not exclusive to property (although commonly associated with property)
5. Negative gearing is an important instrument in promoting businesses to undertake investment which may have longer timeframes in generating returns.
Let us introduce Emma. Emma is a Sales Director earning $200,000 a year. She recently acquired an $800,000 property with a little capital she had saved in addition to the draw-down of a $750,000 investment line of credit whilst using her family home as collateral (to avoid lenders mortgage insurance).
A $750,000 investment loan, with interest at 5%p.a., results in an annual interest expense of $37,500. Additional costs (strata payments, council rates, property management fees, ongoing repairs and maintenance) are $10,000 per annum. This means Emma’s investment property has gross costs of $47,500.
Emma rents the property out for $30,000 per annum. The net cost of Emma’s investment property is $17,500 per annum.
When Emma lodges her tax return, her assessable income is; $200,000 (employment income) +/- other income sources. As Emma has an investment loss of $17,500 on her investment property, her assessable income reduces to $182,500 ($200,000 - $17,500). This then reduces Emma’s tax obligation by $8,575.
Let’s assume Emma’s property increases in capital value over the same period by $17,500 (approximately 4.7%) and Emma decides to sell her property after 12 months and 1 day. Because this is greater than 12 months, a capital gain of $8,750 ($17,500 x 50%) is applied to Emma’s assessable income. Although technically Emma hasn’t made any real return on her investment, her after tax position has improved by $4,288.
Who is negative gearing most appropriate for?
1. High income earners with materially disposable income allowing capacity to wear investment losses
2. Long term investors able to ride out economic cycles and ensure their investment generates capital growth over the long term
3. Investors with a high tolerance to risk that have built up significant equity in their homes but whom also have high levels of private debt that they would to expedite their reductions in via a ‘debt recycling strategy’.
What might change?
Under the coalition government, no change to negative gearing is expected.
Under a Labor government, proposed changes include winding back CGT concessions from 50% to 25% and restricting negative gearing to new investment properties only.
Any advice contained in this article is of a general nature only and does not take into account your circumstances or needs. You must decide if this information is suitable to your personal situation or seek advice. Prior to investing in any particular product, you should read the Product Disclosure Statement.
By Matthew Vickers CFP®, Principal Adviser of Snowgum Financial Services