‘Negative gearing’ is an expression often associated with property investment. Here we explain how it works and why it can make an investment property more affordable.
Very few of us can afford to buy an investment property with our own money. Most landlords need a mortgage to fund their investment property. That’s where negative gearing comes in.
The term ‘gearing’ simply means borrowing to invest. That’s what you’re doing when you use a loan to purchase an investment property. The appeal of gearing is that it lets you invest in an asset of far greater value than you could afford using your own money.
An investment property is ‘negatively geared’ when the cost of owning and maintaining the property (including interest on the loan but not repayments on the principal loan amount) outweighs the rental income you receive. The difference is a loss that can be claimed as a tax deduction, and this deduction reduces the tax payable on other types of income including your regular wage or salary.
How does negative gearing work?
Let’s see an example of how negative gearing can be used in property investment.
Bill’s annual salary is $90,000. On this amount he pays income tax (plus the Medicare levy) of $22,600. Bill decides to invest in an investment property using a loan of $300,000. The property generates annual rental income of $15,000, but the loan interest totals $21,000 each year. He also pays other property expenses (rates, insurance and so on) of $2,000 annually.
As a result of his property investment Bill’s annual income will rise to $105,000 (salary plus rent). However, he can claim an annual tax deduction for rental property expenses totaling $23,000 (loan interest plus other costs). This reduces his taxable income to $82,000. On this amount Bill will pay tax (plus the Medicare levy) of $19,500 - reducing his annual tax bill by $3,080. This is a saving that Bill can put towards his loan payments, invest elsewhere or simply to pay off some bills.
The result is summarised below:
| Without an investment property | With a negatively-geared investment property | |
| Annual salary income | $90,000 | $90,000 |
| Rental income | - | $15,000 |
| Total income | $90,000 | $105,000 |
| Tax deductions (loan interest & other property costs) | - | $23,000 |
| Taxable income | $90,000 | $82,000 |
| Tax (plus Medicare) | $22,600 | $19,520 |
| Tax saving from negative gearing | - | $3,080 |
Which expenses can be claimed on tax?
The ATO classifies the costs associated with owning an investment property as either revenue costs or capital costs. These costs can be claimed at different stages of ownership of the property.
Revenue costs
Revenue costs are the expenses associated with earning a rental income and can be claimed on an ongoing basis. They can be classified as cash deductions or non-cash deductions.
1. Cash deductions
Cash deductions are available irrespective of the age of the property and include expenses such as loan interest, maintenance and repairs, property management fees, landlord insurance, water, council fees, land rates and unit strata levies. Finance set up costs, such as establishment fees, and the cost of the Quantity Surveyors Report (required by the ATO to determine the value of non-cash deductions) can be claimed as one-off cash deductions in the year they are paid.
2. Non-cash deductions
Non-cash deductions include depreciation-related expenses for the building as well as fixtures and fittings (also known as plant and equipment). They vary according to the age of the property and the specific items in the building that wear out over a period of time.
Building depreciation is an allowance available for the cost of constructing the building. It is set at 2.5% of the building cost and is claimable every year for 40 years. The cost of the building is determined by a Quantity Surveyor.
Plant and equipment depreciation is an allowance for items in the building that wear out over time, e.g. carpets, blinds. The depreciation rate of each item varies according to its effective life, i.e. the estimated period over which it can produce an income.
Capital costs
Capital costs include the costs involved in buying and selling an investment property (e.g. solicitor’s fees, agent’s commission) and major improvements such as renovations. They cannot be claimed until the property is sold.
Your accountant can provide advice on the different types of deductions and when they are claimable.
Does my investment property have to be negatively geared?
Not at all. If your investment property delivers a high rental income, or if you have a small mortgage, chances are the property will be positively geared – in other words, it generates a profit each year, whereas negative gearing means you are incurring a loss.
Positive gearing isn’t a bad thing. Some property investment gurus say an investment should deliver a positive result over time, and it may be unwise to select an investment property based solely on the tax benefits it can provide through negative gearing.
At Arafura Finance Broker we are long term property investors so contact us to find out how we can help you in getting the most suitable property investment loans from our lender panel.
The above information is provided for general education purposes only and does not constitute specialist advice. It should not be relied upon for the purposes of entering into any legal or financial commitments. Specific investment advice should be obtained from a suitably qualified professional before adopting any investment strategy.