Below is an excerpt from the Life and Taxes: A Look at Life Through Tax book by Mark Chapman, available now on the CCH Bookshop.
In recent years, investment in property appears to have become a national pastime. Buoyed by steadily rising prices in many cities, strong demand for rental properties — ironically driven in part by first time buyers unable to afford a step onto the housing ladder, and a tax system which is unusually generous by international standards towards property investors, many have seen buying investment properties as a quick and easy way to build a pool of wealth. The result is that over 1.7 million Australians own an investment property. Of those, about 73% own just one investment property, but nearly 100,000 people own more than three investment properties.
Tax is a vital component in any investment decision, none more so than buying a property. Some people blunder into the property market convinced of quick returns and massive tax breaks. The reality is more nuanced and that is what we will investigate in this chapter.
Negative gearing explained
The tax laws of this country contain provisions which in many cases enable taxpayers to offset losses which they incur in one field of economic activity either against future profits from the same activity or against current profits from other fields of activity.
To give a simple example, let’s say that you run a farming business and also have paid employment as a truck driver. In a particular year, you make a loss in your farming business because of poor market conditions. Usually, you would be able to offset that loss against the income you earned from your employment, generating a refund of some of the income tax paid on your employment.
The same rules apply to property investments. If you own and rent out a property, and the amount of income which you earn from the rent is less than the amount of expenditure you incur, the resulting loss can be offset against your other income or profits for the year.
Of the various items of expenditure which you incur in running a rental property, probably the most significant is the amount you pay on your mortgage. The interest element of your mortgage repayment is deductible for tax purposes. Therefore, by gearing your property to the maximum level possible under the rules allowed by your bank, you can also maximise the size of the interest charges you can claim as a tax deduction.
In a common scenario, the amounts which you earn in rent are less than the amounts you spend on your rental property, including mortgage interest plus all the other tax deductible items such as land rates, water rates, estate agent fees, capital works deductions and repair costs.
That means that you’ve made a loss on your rental property and the tax law allows you to offset that loss against your other income.
This is a valuable relief but it needs to be put into perspective. Yes, you’ve generated a tax loss which will allow you to recoup some tax you’ve paid, or are due to pay, on other income. But you have actually made a real economic loss. So, although you might get tax back at your marginal tax rate (between 19% and 47% (49% for 2016/17)), you have actually lost 100% of the shortfall.
What really makes negative gearing so desirable is the way the tax law then treats you when you choose to dispose of the property.
Basically, when you sell a property, you are subject to capital gains tax (CGT) on the profit (which in very simple terms is the difference between what you paid for it and what you sold it for). CGT is levied at your marginal tax rate (between 19% and 47%, as per above). But, if you own an asset for more than 12 months, you become eligible for the 50% CGT discount. This halves the amount which is subject to tax, and is equivalent to halving the rate of tax you pay on the full gain.
People make money from negative gearing on the potentially favourable interaction between the ongoing losses on the rental income and the profit which hopefully will arise on disposal of the property.
In short, you make a series of small, annual losses on your rental income (for which you receive tax relief at your marginal rate) but then at the end, you make a potentially large capital profit on the disposal (which is taxed at half rates, effectively). The large profit on disposal more than outweighs the small, cumulative losses on rental income and overall, you have made a positive total return on your investment. This is particularly the case in the current economic environment where rapidly rising property prices in some capital cities are leading to bumper profits for investors
selling their rental properties (often to other investors).
Bob buys a house in Melbourne for $500,000 in 2010. He pays monthly mortgage payments of $1,600 on an interest-only mortgage and has other monthly outgoings (all tax deductible) of $400. He receives monthly rental income of $1,600. He sells the house in 2015 for $750,000. He has other income of $250,000 per year.
Annual loss on rental
Income: $1,600 x 12 = $19,200
Expenses: ($2,000) x 12 = ($24,000)
Net loss per year: ($4,800)
Bob can offset the loss of $4,800 per year against his other income to generate a tax refund of $2,256 per year ($4,800 x 47%).
On disposal, Bob makes a capital gain of $250,000. After the 50% CGT discount, his taxable gain is $125,000. He therefore has a tax liability (at a rate of 47%) of $58,750.
Bob’s after-tax return over the five-year ownership period is therefore as follows:
Loss on rental income: ($4,800) x 53% x 5 = ($12,720)
Profit on disposal of property: $250,000 less $58,750 = $191,250
Net profit on investment: $178,530
These numbers are provided for illustrative purposes only and reflect tax rates for 2017/18.
Looking at the numbers above, it can be seen that there are potentially large profits to be made by negatively gearing a rental property.
But there are also caveats:
- To work, a negative gearing strategy must operate in a time of rising house prices. If prices are stagnant or falling, the strategy doesn’t work because you don’t make a profit on the sale of the property.
- Negative gearing works best at the top tax rates because those rates give the biggest tax breaks. At the lower tax rates, the benefits shrink proportionately. The ongoing costs of running a property at a loss over many years can stretch taxpayers on more modest incomes to breaking point. Of the 1.9 million taxpayers who declare rental income, it’s estimated that three quarters are earning less than $80,000 per year (and hence getting relief at a marginal rate of 32.5% rather than the top marginal rate of 47% used in the example above).
- Finally, and obviously, the strategy relies on the tax law staying as it is. This area has become something of a political football with some politicians blaming negative gearing for inflating house prices beyond the means of first time buyers. As property investment is generally a long-term strategy, you need to be confident that the rules won’t be changed in a way which will
This chapter from Life and Taxes: A Look at Life Through Tax also covers:
- Tax and property investment
- Capital gains on investment properties
- Holiday homes
- Buying a property with others
- Land tax
- Tax and Airbnb: what you need to know