There’s a positive appeal of borrowing money to buy shares or property, even though the name it’s given is ‘negative’ gearing.
Negative gearing is just money talk for something pretty simple.
Imagine you borrow money to buy a rental property. This borrowing is called gearing.
Now if you rent this property and receive $400 a month in rent, but your monthly repayment on the loan for the property and other costs were $500, then you’ve borrowed for a negative result i.e. you’re out of pocket to the tune of $100.
That’s negative gearing in a nutshell. Keep reading…
OK that sounds simple but why would anyone do something that creates a loss of $100?
Well, they get to receive the rent of $400, which helps pay off the loan. And the house, over time, will more than likely increase in value. In money talk terms, — this is called capital gain. Capital gain is the increased value of a property or any asset that happens over time.
But hang on, wouldn’t it be hard to meet the shortfall of $100 each month? And let’s face that shortfall could be $1,000 depending on how much you borrow. Here’s the answer: the tax system helps. But the full answer takes a bit of explaining so stay with me on this.
Let’s assume after taking on board the rental income received, and then deducting the expenses for holding the rental property, such as rates, water, insurance, real estate fees, repairs, etc. as well as the interest repayments, the total ‘loss’ over a year is $4,640. That’s a big loss, how is it made sufferable?
Well, just as income is taxed when you earn it, the tax system allows you to get effective refunds on losses. If the borrower was on a 47% tax rate (for simplicity), then to work out the ‘saving’ you’d take that $4,640 loss and multiply it by the tax rate of 47%. This equals $2,180.80. Now, if you take this away from your loss of $4,640, you wind up with a loss of $2,459.20. A loss of $2,459.20 looks more manageable than the hefty $4,640.
And believe it or not, the Tax Office lets you fill out a form, which is called the PAYG income tax withholding variation (ITWV) application (NAT 2036). This informs the ATO when your overall taxable income will be reduced by such things as a negatively-geared property. This means that your paymaster at work can actually adjust your weekly, fortnightly or monthly tax to effectively give you your tax refund linked to the property early. Effectively, you get your year-end tax refund in smaller amounts every payday. That’s a big help with managing your cashflow.
In our example above, the monthly refund would be $2,180 divided by 12 months = $181.67.
So you’d actually get this in your pay packet to help make the rented property play happen. Yes, it’s still a gamble but if your property is in a sought-after area and a property boom comes along, then the negatively-geared, personal investment decision could be a real winner for you.
As you’d expect, there are issues to consider. For starters, if you’re in a lower tax bracket, such as the 34.5% one (including the Medicare levy of 2%), then the tax refund payoff isn’t as big. The loss of $4,640 times 34.5% gives a tax saving of $1,600.80. This isn’t as good as the $2,180.80, which is the tax benefit when your tax rate is 47%.
Negative gearing isn’t for everyone. It’s certainly more advantageous for higher income earners in higher tax brackets. The higher income person on $120,000 a year, say buying the exact same one-bedroom apartment in Sydney’s Darling Harbour, as someone on $35,000, is in a less risky position, thanks to tax.
And negative gearing works better in a period of inflation, as this tends to push up house prices and rents. This can give you a big capital gain benefit. Low inflation can undermine capital gains.
And if there’s a lot of inflation around and interest rates go up, the monthly payments can go ballistic, which could ruin the equation between income received from the property and the costs or outgoings of paying for it.
So that’s the positive news on negative gearing. If you are thinking of borrowing to buy shares or property and you’re interested in understanding how negative gearing could work in your favour, then write down a list of questions and ask an accountant BEFORE you borrow a cent. Where can you find a good accountant? That’s the topic for another day. Watch this space!
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.