I remember
when I was younger, asking my mum what Negative Gearing was. I had
seen it advertised everywhere, from free seminars on television to articles in
magazines and newspapers, it seemed to be the buzz phrase of the day. My mum
explained that negative gearing was when you buy a house and rent it out to a family and let the rent pay for the mortgage. I guess she kept it simplified because I was not
even a teenager at that stage but even still, it sounded like a good idea to me, you
basically get a house for free! So what could possibly go wrong?
A few years later, when I really started to look into investing, I began to see the “negative” part of negative gearing. I guess the answer was always in the name, if something is called negative, then it is never
going to be a good thing, right?
So, what is negative gearing? Put simply, negative gearing is
purchasing a property as an investment, where the money coming in (rent) does not cover
the money coming out (loan repayments, maintenance, agent's fees etc.) and you are forced to use your own income to cover
the difference.
But so
many people have made so much money out of negative gearing, "how can it be a
bad thing?" I hear you ask. Well to make money out of a negatively geared property, the value of the property needs to rise consistently over the medium to long term of the loan. Back when negative gearing was really popular, this was the case but in the not-so-flash property market of today, you need to give things a second and third look before jumping in. In a rapidly rising market like Australia had during the
2000s, it was next to impossible to lose money investing in property. In the
end, all these people who invested in negatively geared property were able to
still make money despite an unsustainable investment strategy.
So, what
makes it so unsustainable? Well it is a fact that the majority of property
investors own 2 or less properties, I cannot remember the exact percentage, but
I believe it is something like 90% of property investors 'only' own 1 or 2 properties. The reason for this is simple, the majority of properties are negatively geared; they cannot afford to hold any more.
As an example, let’s say you have $1,000 extra cash flow a month. Because a negatively geared property is taking money out of your pocket, assume it costs you $500 per month to maintain the loan (cover the difference between the rent and the loan repayments). Already you can see that you are only able to cover 2 properties, as after that, you are out of extra cash flow.
So why do
people negatively gear into property? Well again, the answer is simple. They have to. They want to invest in property because according to a lot of people, it is a
great way to invest, just about risk free, just about a guarantee to make a
return and the saying “safe as houses” does come from somewhere after all.
As it stands now, if you want to invest in property as part of your portfolio, you will see that almost all of the available properties are negatively geared. This is mainly due to the extremely high house prices in Australia, particularly in the major cities. House prices rose dramatically over recent times, and the increase in rent simply did not keep up. I remember when I was renting back in 2009; we paid $550.00 per week for a 3 bedroom house in Sydney. Looking at comparative sales nearby, the house would have been easily worth about $800,000. Assuming an interest rate of 7.00% per annum, that gives a weekly interest repayment of $1,076.00. Repayments at this level don't even begin to "eat" away at the principal amount as the rent is nowhere near the amount needed to service the loan. This is the situation across most of Australia, rent prices just do not come close to the loan repayments and all the properties have to be negatively geared.
Another reason that people invest in negatively geared property is to reduce
their tax bill. People are under the
illusion that they can end out better off because they're paying less in tax. Of course it is true that
you can claim expenses on the house on your tax return, but this is offset by
the money out
of your pocket to service the loan, so you still end up out of pocket. Let me show you an example:
Your initial taxable income is $150,000 per year
Tax rate of 45%
Rent collected of $600 per week
Interest repayments of $1,100 per week
Other deductions of $5,000 per year (property maintenance, fees etc)
of your pocket to service the loan, so you still end up out of pocket. Let me show you an example:
Your initial taxable income is $150,000 per year
Tax rate of 45%
Rent collected of $600 per week
Interest repayments of $1,100 per week
Other deductions of $5,000 per year (property maintenance, fees etc)
Option 1 – Not investing in property
Taxable Income = $150,000
Tax Paid = $150,000 - [$150,000 x (1 – 0.45)]
= $67,500 (approximately)
Net Income = $150,000 - $67,500
= $82,500
Tax Paid = $150,000 - [$150,000 x (1 – 0.45)]
= $67,500 (approximately)
Net Income = $150,000 - $67,500
= $82,500
Option 2 – Investing in property
Taxable
Income = $150,000 + $600 x 52 - $1,100 x 52 - $5,000
= $119,000
= $119,000
Tax Paid =
$53,550
Net Income
= $119,000 - $53,550
= $65,450
= $65,450
So as you
can see, your net income is almost $20,000 less in this example, so just to break even with a negatively geared property, you need to ensure there is at least $20,000 in
capital gains over the course of a year. Now as I said earlier, when
the property market was going well, this was fine, but without the large rises, negative geared property should be heavily scrutinised before committing to buy.
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Thank you for writing a great post. Love the examples. Keep up the great work.
ReplyDeleteNo problem, thank you for reading! have you got any topics that you would like us to discuss next?
ReplyDeleteThere are some ways on how we can ensure the safety of our Real Estate Investment. We can get other helps from professional agent of real estate. They are more knowledgeable with this issue on how to take care of this type of investment. I hope that we can take care of our needs for our family with the earnings that we got from this business.
ReplyDeletehttp://www.realestateinvestment-australia.com.au/