Negative gearing could be your answer to a sustainable tax cut. ·Getty
Borrowing money to invest comes with some serious tax perks, where you can claim a tax deduction for the costs of borrowing money to grow your investments.
Borrowing to invest helps you invest more than you can with just your savings alone and cut your tax bill at the same time.
This is why negative gearing is one of my favourite tax-saving and wealth-building strategies.
What is negative gearing?
Gearing means borrowing to invest. The negative part refers to the ‘cash flow’ of your investment, with the most common form of negative gearing in Australia being investing in property.
Effectively, if you borrow to invest and the total costs of the investment are less than the income generated, the cash flow is negative.
Now you might be wondering why on earth anyone would want to choose an investment where they’re losing money, and it’s a good question.
There are two reasons. The first is the tax breaks, because the cost of your investment is able to be claimed as a full tax deduction (more on this below).
The second reason is that the income of your investment is only one part of the picture, the other is your growth.
Cost of owning an investment property
When you own an investment property, you receive income through rent and then have to cover the costs associated with owning the property.
The biggest cost is typically mortgage interest, then you have ongoing property expenses like rates, insurance, and maintenance.
I’ve included an example showing the costs of a $1 million investment property below, assuming you borrow the full amount of the purchase ($1 million).
Mortgage interest at 6 per cent = $60,000 p.a.
Ongoing property expenses at 1 per cent = $10,000
Total costs: $70,000 p.a.
You would then receive rent, and based on the Australian average of 3.7 per cent this would equate to $37,000 in rental income each year.
So the net cost of your $1 million investment property would be $33,000 (income of $37,000 less costs of $70,000). You can see in this case that the ‘cash flow’ of your investment property is negative, meaning you’d be in a negative gearing situation.
Property tax breaks and upside
If your income is above $45,000 p.a., your marginal tax rate + medicare levy is at least 34.5 per cent, which means for every dollar of tax deductions you have, you’d receive a tax refund of $0.345.
If your income and tax rate is higher, the tax deductions will be even higher.
But assuming your tax rate is 34.5 per cent, based on a negative gearing deduction of $33,000 in the example above, you would receive a tax refund of $11,385.
This brings the after tax cost of holding your investment property down from $33,000 to $21,615 p.a.
The obvious next question is why you’d want to have an investment that is costing you almost $22,000 a year, and it’s a valid one to ask.
The answer lies in the growth in the value of the property over time.
In Australia, the long term growth rate on property is 6.3 per cent, which means a $1 million property will increase on average by $63,000 each year.
If you follow the numbers through, you’re paying a cost of $21,615 each year to receive a benefit of $63,000, meaning the net benefit to you is $41,385 every single year.
The numbers stack up nicely here.
There are very few investments out there that will deliver you an extra $40k+ every year, cut your tax bill, and use the rules to your advantage. Negative gearing can hit all three.
Buying property comes with risk
You should be aware that any time you borrow to invest, you are taking on risk.
Particularly today, there are a lot of people that weren’t as aware of this risk as they should have been when they bought property, and with rising interest rates this presents a challenge.
If you’re thinking about negative gearing (or any other investment strategy) it’s important you take the time to understand your risks, manage them as much as needed, and that you’re smart about your planning.
Specifically when buying property, you should always look ahead to ensure you can afford the property not just today or tomorrow, but into the years ahead.
The wrap
Negative gearing is a strategy that can cut your tax bill this year, and every year moving forward, giving you more money to help fund your investing, or just direct to your lifestyle spending.
At the same time, this strategy allows you to acquire more investments than you can get with just your savings alone, and more good investments behind you mean more growth in your asset and wealth position into the future.
The strategy is a solid one for people who want to be smart and use the rules to their advantage to get ahead faster, but it does come with risk.
If you want to get results without adding more stress and pressure to your finances, you must be smart with your planning and risk management.
But this risk can be managed well with the right approach, and when you get this strategy right it will seriously accelerate your financial progress.
Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth www.pivotwealth.com.au, and Author of the Amazon Best Selling Book ‘Get Unstuck: Your guide to creating a life not limited by money’. www.getunstuckbook.com.au
Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.
