NEGATIVE GEARING

Chapter 2 - Examples of negative gearing

Capital gains​

Repayments

Andy is a self-employed plumber earning $100,000 a year after expenses. His marginal tax rate is 37%. Andy already owns one home, valued at $600,000. Andy has a debt of $200,000 on this home, meaning he has $400,000 in equity. Here is how his assets look:

Home: $600,000

Loan: $200,000

Equity: $400,000

Andy decides to also buy the house next door. It is also valued at $600,000. He offers his own home as security, as well as the investment property, and borrows the entire $600,000, as well as the $30,000 needed for stamp duty. After he makes the purchase, Andy’s assets look like this:

Home: $600,000

Investment property: $600,000

Total Assets: $1,200,000

Home Loan: $200,000

Investment Loan: $630,000

Total Debt: $830,000

Equity: $370,000 (total assets minus total debt)

Andy’s equity has fallen, but only by the amount of the stamp duty he had to pay.

So, the loan constitutes the ‘gearing’ part of the term ‘negative gearing.’ Now we come to the negative part.

Andy appoints a property manager and they pay all of the ongoing costs of the property, such as insurance and council rates and their own management fee. These come to $3,000 a year. He receives a rental yield of 3% on the property, or $18,000. The interest rate on his investment loan is currently 5%. On a loan of $630,000, this equates to $31,500.

This is how things look:

Income: $18,000 a year

Expenses: $31,500 interest

$3,000 other costs (rates, management and insurance)

Net income: -$16,500 a year (income minus total expenses)

These figures show that Andy makes a loss of $16,500 each year. Andy is allowed to ‘add’ this figure to his other income. But when you add a negative number, you actually subtract. So, Andy’s taxable income falls from $100,000 to $83,500. The tax payable on $100,000 of income is $24,947. The tax payable on $83,500 in income is $18,842.

This means that negative gearing has reduced Andy’s tax liability by $6,105. This means that the loss of $16,500 on holding the property is partially offset by $6,105 of less tax that is payable. Thus, the after-tax loss is reduced to $10,395.

As long as the value of the property increases by more than $10,395 per year, overall Andy will be made more wealthy because of the investment. $10,395 is 1.7% of $600,000. So, as long as the property market rises by more than 1.7%, the short term loss that Andy makes will be offset by the longer–term capital gain.

In the 10 years to December 2016, the long-term average returnfor residential Australian property was 8.0%. (ASX/Russell). This includes rent, which is typically about 3%, and so the rate of capital growth was around 5%. If this rate were to continue, then Andy would make a solid profit.

For the 20 years to December 2016, the overall return for residential property was 10.5% (same source), implying capital growth of around 7% per year. Again, this rate would allow Andy to make a solid profit.

Capital Gains Tax

If Andy was to sell the investment property, he would have to pay capital gains tax. If he holds the property for more than 12 months, any CGT liability is halved. This means that half of the capital gain is not taxed, and the other half is taxed at Andy’s tax rate of 37%. Overall, then, the capital gain is taxed at 18.5%.

If we ‘add this figure back’ to the required rate of capital growth on Andy’s property (1.7%), the figure rises to 2.1%. This means that, if the property rises by at least 2.1% each year (on average), then Andy will have made a gain even after he sells the property and pays capital gains tax.

That said, our advice with property is usually to keep it for the very long term – maybe even forever. And if you never sell a property, you never pay capital gains tax.

Repayment

Andy should then direct all of his repayment efforts to the home loan that existed before he bought the property. This is because the interest on that loan cannot be offset against his taxable income. This makes the interest more expensive, and Andy should aim to repay that debt as soon as possible. We discuss this further below in the section on debt management.

1. What is negative gearing
3. Long term growth & main asset classes

 ©2016 WHOLE WEALTH

  • White LinkedIn Icon
  • White YouTube Icon
  • White Instagram Icon
  • Twitter Clean
  • White Google+ Icon