Time to read : 6 Minutes
Few areas of the tax system have attracted as much attention as the rules around negative gearing. A legitimate use of the rules to help mum and dad investors get ahead – or a rort at the expense of the rest of us? Whatever your view, there’s no doubt this area of tax law is politically controversial and with a General Election around the corner, it’s under scrutiny again.
What exactly is negative gearing?
Australian tax laws contain provisions which can enable taxpayers to offset losses incurred in one field of economic activity, against future profits from that activity or current profits from other fields of activity.
Here’s a simple example:
Let’s say that you run a small farming business and also work as a truck driver. In a particular year, you make a loss in your farming business because of poor market conditions. Usually, you would be able to offset that loss against the income you earned from your employment, generating a refund of some of the income tax paid on your employment.
The same rules apply to property investments. If you own and rent out a property, and the amount of income which you earn from the rent is less than the amount of expenditure you incur, the resulting loss can be offset against your other income or profits for that year.
One of the most significant expenses incurred in running your rental property is likely your mortgage repayment. The interest part of your repayment is deductible for tax purposes. So, by gearing your property to the maximum level possible under the rules allowed by your bank, you can also maximise the size of the interest charges you can claim for your tax deduction.
What rental property expenses can you deduct?
Investment property expenses typically include:
mortgage repayments
land rates
water rates
insurance
capital works
minor repairs.
In a common scenario, what you earn in rent is usually less than the amount you spend on your rental property. This means that you’re making a loss on your rental property and our tax laws currently allow you to offset this loss against your other income, like your salary.
This is a valuable relief but it needs to be put into perspective. Yes, you’ve generated a tax loss which can allow you to recoup some of your income tax – but you have actually made a real economic loss. So, although you might get tax back at between 19% and 45% (depending on your marginal tax rate), you have actually lost 100% of your shortfall.
What makes negative gearing so desirable is the way the tax law treats any profits made from the sale of your rental property.
What happens when you sell your investment property?
Basically, when you sell your property, you’re subject to capital gains tax (CGT) on the profit (which in very simple terms is the difference between what you paid for it and what you sold it for). CGT is levied at your marginal tax rate (between 19% and 45%, as per above).
However, if you own an asset for more than 12 months, you become eligible for the 50% CGT discount. This basically halves the amount which is subject to tax, and is equivalent to halving the rate of tax you pay on your full gain.
Where people make money from negative gearing is on the potentially favourable interaction between their ongoing losses on their rental income, and their profit when they dispose of their property.
Can you break it down a bit more?
In short, you make a series of small, annual losses on your rental income (for which you receive tax relief at your marginal rate) but then at the end, you make a potentially large capital profit on your property sale (which is taxed at half rates, effectively).
The large profit you make at disposal more than outweighs the small, cumulative losses on your rental income and – hey presto! Overall, you’ve made a very substantial total return on your property investment.
This is particularly the case in the current economic environment, where rapidly rising property prices are leading to bumper profits for investors selling up their rental properties (often to other investors).
Want to see a numerical example?
Bob buys a house in Melbourne for $500,000 in 2016. He makes monthly mortgage repayments of $1,600 and pays for other monthly outgoings (all tax deductible) of $400. He receives monthly rental income of $1,600. He sells the house in 2021 for $750,000. He has other income of $250,000 per year.
Annual loss on rental: | $ |
|---|---|
Income ($1,600 x 12) | $19,200 |
Expenses ($2,000 x 12) | ($24,000) |
Net loss per annum | ($4,800) |
Bob can offset his loss of $4,800 per annum against his other income to generate a tax refund of $2,160 dollars per year ($4,800 x 45%).
On disposal of his rental house, Bob makes a capital gain of $250,000. After the CGT 50% discount, his taxable gain is $125,000. He therefore has a tax liability (at 45%) of $56,250.
Bob’s after tax return over the five year ownership period is therefore as follows:
Loss on rental income ($2,640 x5) | ($13,200) |
|---|---|
Profit on disposal of property ($250,000 less $56,250) | $193,750 |
Net profit on Bob’s investment property | $180,550 |
These numbers are provided for illustrative purposes only.
Looking at Bob’s numbers, you’ll see there are potentially large profits to be made by negatively gearing a rental property.
Bottom line
To work, a negative gearing strategy must operate in a time of rising house prices. If prices are stagnant or falling, you can find yourself in a financial pickle.
Negative gearing works best at the top tax rates because those rates give the biggest tax breaks. At the lower tax rates, the benefits shrink proportionately. The ongoing cost of running a property at a loss over many years can stretch taxpayers on more modest incomes to breaking point. Of the 1.9 million taxpayers who declare rental income, it’s estimated that three quarters are earning less than $80,000 per year (and getting relief at a marginal rate of 32.5% rather than the 45% used in the example).
Finally, and obviously, the strategy relies on the tax law staying as it is. Having said that, there are no firm proposals to change the law, particularly after the Labor party got burnt with its policies to reform negative gearing at the last election.
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Financial disclaimer
The information contained on this web page is of general nature only and has been prepared without taking into consideration your objectives, needs and financial situation. You should check with a financial professional before making any decisions. Any opinions expressed within an article are those of the author and do not specifically reflect the views of Compare Club Australia Pty Ltd.
