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Negative Gearing - Negative Or Positive?

Creating wealth through purchasing an investment property is a well-established practice in Australia. Buy the right property in the right location and you are on the path to prosperity.

If it was only that easy!

Make no mistake, buying an investment property carries risk. It is a medium to long term investment, interest rates and property markets can be volatile and you need to be earning other income to cover the negative cash flow associated with a negatively geared property. Of course, get the selection process right and the result can be a financial windfall, however, we have also seen the strategy turn into a financial nightmare. It’s only when you combine the right property in the right location acquired at the right price in the most appropriate ownership structure that the strategy delivers the best financial outcomes. 

What Are the Claimable Deductions?

While the tax benefits are certainly important, they shouldn’t be the only driver behind the decision to buy an investment property. The Tax Office allows property investors to offset a number of deductions against the rental income they receive. Expenses including mortgage interest, management fees, rates, insurance and repairs and maintenance can all be claimed. Please note, you need to be careful with the distinction between a tax deductible repair and a non-deductible capital improvement for tax purposes. Investors are also entitled to a deduction for ‘non-cash’ expenses like the wear and tear on the structure of the building and assets contained within the property including furniture and fittings. This deduction is known as ‘depreciation’.

In addition, the ATO also allows a ‘non-cash’ deduction for the Building Allowance (or Capital Works Deduction) which lets property investors claim the building construction costs over a 25 to 40 year period. Basically, you can claim a deduction if construction of the property began after 17th July 1985 and the property is used for residential accommodation to produce rental income. If the property construction commencement date is between July 18, 1985 and 15th September, 1987 the building allowance rate is 4%. If construction commenced after September 15, 1987 the rate is 2.5%. The construction costs must be calculated by a quantity surveyor.

Compare the Pair

To illustrate the potential tax benefits of owning a negatively geared investment property, let’s examine the situation of two ‘average’ Australian taxpayers who both earn $80,000 per annum. As you’ll see from the table below, taxpayer (A) doesn’t own an investment property and pays $18,802 in taxes (including the Medicare Levy) after he claims $1000 of basic work-related expenses such as uniform costs and donations.

The other taxpayer (B) who earns the exact same salary of $80,000 buys an investment property for $500,000 and borrows the full amount from the bank at 5%. It is an interest only loan so the interest is approximately $25,000 for the full year. The rental income on the property is $445 per week. He claims the same work related expenses as Taxpayer A, but he is also able to claim deductions for expenses involved in holding the property including the management fees, insurance, rates, and repairs. These expenses for a typical two bedroom property are estimated to be around $3,500 per annum. Taxpayer B also obtained a depreciation schedule which showed they could claim an extra $8,500 in building allowance deductions.

The following table ‘compares the pair’ and shows their before and after tax outcomes:

Taxpayer A (no investment property)

Taxpayer B (owns an investment property)

Gross salary

$80,000

Gross Salary

$80,000

Property Rental income

N/A

Property Rental income ($445 x 52 weeks)

$23,140

Gross Income

$80,000

Gross Income

$103,140

Property expenses

N/A

Property expenses (including interest)

-$28,500

Depreciation deductions

N/A

Depreciation & Building Allowance Deductions

-$8,500

Work Related Expenses

-$1,000

Work Related Expenses

-$1,000

Total deductible expenses

-$1,000

Total deductible expenses (work related expenses + property expenses + depreciation)

-$38,000

Taxable income

$79,000

Taxable income

$65,140

Tax payable (including Medicare Levy)

$18,802

Tax payable (including Medicare Levy)

$14,020

Net Take Home Income (Income minus cash expenses and tax)

$60,198

Net Take Home Income (Income minus cash expenses and tax)

$59,620

The depreciation deductions in Taxpayer B’s scenario have been calculated using the diminishing value method and are based on the first financial year of ownership. This is an illustrative example and every person’s financial and tax situation is different which is why we recommend you seek independent advice before buying an investment property.

As you can see, Taxpayer A’s net income after he pays $18,802 in taxes (and the medicare levy) is $60,198. Although Taxpayer B earns the same take home wage, because of the negatively geared property he only pays tax of $14,020 and takes home $59,620. In effect, owning the property is costing him $578 per annum or $11 per week.

Investors thinking of purchasing a property should always obtain expert tax advice and to maximise the depreciation deductions you will need a report prepared by a specialist Quantity Surveyor. This case study is based on a number of assumptions and investors should always seek our advice to discuss the tax implications of negative gearing.

This article is not intended to provide financial or taxation advice and should not be relied upon for that purpose.

Click HERE to download the full edition of The Business Accelerator Magazine for March 2016

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IMPORTANT DISCLAIMER:This newsletter is issued as a guide to clients and for their private information. This newsletter does not constitute advice. Clients should not act solely on the basis of the material contained in this newsletter. Items herein are general comments only and do not convey advice per se. Also changes in legislation may occur quickly. We therefore recommend that our formal advice be sought before acting in any of these areas.

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