What is Negative Gearing and Why It’s NOT a Strategy?

This video is part of our Negative Gearing video series.

You’re currently watching Video 1.
Video 2: Labor’s Negative Gearing Policy Blunders (Part 1) – Watch here
Video 3: Labor’s Negative Gearing Policy Blunders (Part 2) – Watch here

 

Transcript:

Hello, Ben Kingsley here. There’s a lot of discussion and debate around property at the moment and Negative Gearing. So I thought I’d set the record straight in this series of short videos around What Is It and What Type of Impact that’s going to have on the Marketplace if there’s going to be some changes made to negative gearing.

I want to start with the basics in understanding what it is and how does it work. Let’s take a look.

So we’ve got effectively, money coming in and that money coming in is what we refer to as obviously the rent that we get. Let’s say we get $20,000 in rent for the year. Now, what’s our money going out? Our money going out over here would be things like holding costs. Let’s put those holding costs in and what can these things be? You know, maintenance and repairs. We’ve got repairs and we’ve got, maybe property management fees as examples. Now let’s say as an example, that’s $1,000 for the year. So if we own the property outright, we had $20,000 coming in and we had $1,000 going out. We would have an income of $19,000. Now that $19,000 is added to our income tax for that year and we pay tax on that income. So we are going to pay tax.

Now that’s NOT negative gearing.

That’s just a property that doesn’t have any other costs associated with it but what if we introduced some other costs? What other costs are there and this is where the gearing comes in. Let’s start understanding the concept of gearing… we’re going to use that word.

Gearing is effectively mean that we borrow the money. We’re going to borrow to invest and in this particular case, we borrow a bit of money and the interest costs… Let’s say that was also $20,000 for the year. The other type of costs that we might also be able to write down or write off is a thing called depreciation. Depreciation works with the assumptions that fixtures and fittings and the building itself, is going to deteriorate over time. So we’re able to write those off. It’s not actually a physical cost that we have to pay but it helps in terms of being able to claim that cost against your income for that year.

Let’s say in this particular case we had $5,000. That would mean if we got the $1,000, the $20,000 and $5,000, then we had $26,000 in claimable costs. Okay. So that would mean if we had $20,000 coming in for rent and $26,000 going out, we would be operating that property at a loss for that year. That loss would simply be $6,000. THIS is the negative gearing piece.

We’ve got the gearing coming in here, the property is running at a loss and we’ve made this $6,000 loss. Now, we were able to offset that $6,000 against our PAYG income or our pay-as-you-go withholding income. Different people are on different marginal tax rates and that will be affected. So let’s say hypothetically, that marginal tax rate is 50%, the highest you can possibly get for ease sake. That would mean that there’s $3,000 that we would be able to claim back but there’s still $3,000 that we’ve completely lost.

So if anyone’s thinking about investing in property and continuing to run at a loss, well they’ve got rocks in their head.

Because that’s not good management. That’s not good investing.

What we need to understand is that negative gearing is only a moment in time and you can understand that the interest cost would be adjustable by how much you borrow. If you borrow more, you might have higher interest costs early but if you borrow less, that interest cost could be low which I demonstrated in the first example where we had no interest cost at all. The property was positively delivering income.

Ultimately, we have to pay tax on that income. If we were to draw a diagram of time and value, we would start to see how it looks like over the years. So we go time here in years and then we look at a midpoint which is our break-even point. That’s zero dollars and we might have -$5k, -$10k and up here we have $5k. I’m going to keep it going because it’s really important to understand this. We’ve got $10k, $15k etc. You might start off where you are in negative territory, and then you move through as you pay down that debt, the rent goes up. Inflation plays a role in that. So if we think about our break-even point and you’re still going on over time, we have a period where we are in negative. Running the property a loss which would mean we’d be able to have some tax refunded to us. So there’s a tax refund here in terms of offsetting other income or tax that we’ve paid. When it passes that line and goes to neutral or positive, it means we have tax payable.

And this is what many people don’t understand or are missing the point.

You don’t invest in property to run it at a loss. You invest in property to make a gain over time. The tax refund that you’re getting earlier on helps you from a cash flow point of view and it helps the typical mum and dad from investing. High-income earners in some cases can run properties at losses so, it’s not going to stop the high-income earners from continuing with this strategy but if you were to ban negative gearing for mum and dad investors, then ultimately you’re going to have a series of consequences. Both intended and unintended associated with that. Which means less investment and also means less rental accommodation available. And ultimately, this means higher rents. But I’ll explain that in one of the upcoming videos.

To close off, this is what negative gearing is with the final point around the taxation story.

When we think about tax, there’s a couple of taxes that we pay. We get a tax refund when we experience a loss for that year but what tax are we paying? What tax do property investors pay?

In terms of what’s tax payable, well there’s quite a bit. I’m going to try and squeeze them all in here, but obviously, from a state level, we have stamp duty. Now stamp duty is a one-off, so we pay that as a one-off cost but when you own investment properties, you also pay land tax and that land tax is every year. Then from a Federal point of view, we also have other costs in taxes that we have to pay such as, it’s part of our income tax. Once it becomes positive, we pay income tax. And then if we sell that property, we pay a lot of capital gains tax. So you’ve got capital gains tax as well as the income tax that you will have to pay each year.

It’s crucial to understand that a property investor adds a significant amount of tax revenue at both the State and Federal level. The negative gearing portion of that time is only early and then over that period of time, it becomes positively geared.

Now you might say people are just speculating in property.

We disagree with that.

You invest in property for the long term, you don’t invest for two or three years. That’s too expensive to do, and as we have seen at the moment, property prices don’t always go up. The longer you hold that property, the better position you’re going to be in. That’s the concept of gearing. Adding gearing which is really the biggest cost you have in terms of the interest that you’re paying.

If interest rates are lower, that cost basis is lower. Some properties can also move to positively geared earlier if that interest cost is lower. It’s important to understand there are quite a few moving parts to this, but the fundamentals are this:

You invest in property for LONG TERM passive income to supplement your superannuation and your retirement income. And that will mean that you’ll be less of a burden on both the State and Federal Governments because if you can self-fund your own retirement, then you’re in a greater position to enjoy life. But also be less of a burden on the tax person.

Thanks for watching.

 

 

This video is part of our Negative Gearing video series.

You’re currently watching Video 1.
Video 2: Labor’s Negative Gearing Policy Blunders (Part 1) – Watch here
Video 3: Labor’s Negative Gearing Policy Blunders (Part 2) – Watch here