IS NEGATIVE GEARING WORTHWHILE?

"Negative gearing" has become a popular tax-saving device in recent years. Basically, negative gearing means borrowing money to buy an income-producing asset. The interest is tax-deductible. The usual rate of return on a rental house is about 5% and on a rental unit is about 7% This is after claiming all deductions including depreciation but not including mortgage interest as a deduction. The interest payable on a property loan at present is about 10% One can see that if one borrows at 10% and gets a return of 7%, a loss will be sustained. The borrower hopes to cover this loss by a rise in property value. The rental loss will be deductible from the tax-payer's other income. Part of the loss will be covered by an increased tax-refund.

Negative gearing is worthwhile if a) the taxpayer is in a high tax-bracket, for example, with a taxable income in excess of $35,000 and b) the value of the property is going up. If the value of the property is static or going down, then negative gearing is not a good method of investing.

Let us take a hypothetical example. Michael O' Brien is a public servant. Both he and his wife work. Michael earns over $40,000 pa. Money is accumulating in the bank and they are wondering how to invest it. Michael would like to reduce his tax liability. On a salary of $40,000, his top tax bracket is 45.5% He talks to friends at work who are in the same boat and they suggest "negative gearing".

Michael buys an investment property on 1st July 1992 at a cost of $100,000 (including costs of purchase). He obtains a 100% loan from the bank at 10% pa. It is an interest-only mortgage which means that he repays the principal only when he sells the property. He gets the usual 5% return on his investment. This is before charging mortgage interest. Michael pays $10,000 interest each year. Consequently, he makes a loss of $5,000 (i.e. net rent of $5,000 less interest of $10,000). He claims the loss on his tax return. His upper tax bracket if 45.5% Consequently, he gets back from the Tax Office 45.5% of his loss of $5,000. This comes to $2,275. On the 30th June 1994, he sells the unit for $120,000 (after deducting costs of sale). He repays the mortgage of $100,000. He is also up for Capital Gains tax on the profit on sale. The Capital Gains tax comes to $3,576. Has Michael won or lost on his investment? Let us see.

INCOME
Net Profit, year 1     5,000
Net Profit, year 2     5,000
Additional tax refund, year 1     2,275
Additional tax refund, year 2     2,275
Sale of property 120,000
TOTAL INCOME 134,550
PAYMENTS
Cost of property 110,000
Interest, year 1   10,000
Interest, year 2   10,000
Capital gains tax paid     3,576
TOTAL PAYMENTS 133,576
NET PROFIT ON VENTURE   $        974

Michael is left with a small cash surplus of $974 to compensate him for all the work he has done in buying the property and then liaising with the estate agent in letting and subsequently selling the property.

You should note that the property increased in value over the two years from $100,000 to $120,000. This is approximately an increase of 10% pa. With such an annual increase, Michael has broken even approximately.

The lesson to be learned from this example is that if property values increase by10% pa, then "negative gearing" is worthwhile. If property values increase by less than 10% pa or remain static or go down, then "negative gearing" not the way to go.

This example is postulated on present conditions e.g. that interest rates are 10%. It also assumes a top tax rate of 45.5% If these variable change, then obviously the capital growth required to break even will also change.

TAX TIP

If you are thinking of purchasing an investment property, here is a tip. Buy a property that was constructed after 18th July 1985. The reason for this is that, in general, depreciation at 2.5% can be claimed on buildings constructed after that date. It is important to note that it is only the cost of construction that can be depreciated. The cost of the land must be excluded. It is unfortunate that many taxpayers, who are entitled to this claim, neglect to claim it.

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Copyright 1994.

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