So if you ask ten average investors, why is real estate such an attractive investment opportunity? My guess would be that at least 9 out of 10 would say it’s because of the tax benefits. One of the most notable tax benefits is in the form of negative gearing.
Negative gearing was my saving grace when my early retirement plan faltered. It also served as the foundation for growing my real estate portfolio, like any other investors.
The following post serves as an introduction to negative gearing, summarising the key benefits along with some of the potential pitfalls.
What Is Negative Gearing?
Negative gearing is a government-incentivised, financial leverage arrangement. If that definition seems vague and unhelpful, perhaps the following example may explain the concept.
Say you purchase a rental property with a mortgage. The cash inflows will be your rental income, whereas your cash outflows will be a combination of mortgage interest (and principal repayments), maintenance fees, council dues, levies, and taxes.
If your cash inflows are less than your cash outflows, your rental property will be operating at a loss. Some governments permit owners to offset these losses against your personal income. This sums up negative gearing.
So Who Benefits From Negative Gearing?
Negative gearing hinges on the premise that the income-producing asset (i.e. rental property) will cover the costs of owning the asset over time. As such, negative gearing is a form of front-loading your costs in a tax-advantageous manner.
At the outset, retail investors benefit from this arrangement. If you were a beginner real estate investor, and did not have sufficient cash flow to cover your initial losses, the absence of negative gearing would lead you to financial ruin. As such, it incentivises those considering real estate investment as an engine of wealth creation.
The other noticeable benefit is it reduces your annual tax bill. As your personal income increases, so does your tax bracket. The ability to deduct your property losses against your personal income serves to lower your taxable income, and hence lower your total tax due. This was a major advantage to me personally, particularly as I advanced in my career and my personal income grew.
On the flip-side, governments also benefit from this arrangement. In the absence of retail investors, the government would likely need to ensure there is adequate housing supply. This infrastructure outlay will prove costly and inefficient, and may result in increased taxes to cover these additional costs. Negative gearing is the inverse approach, as it transfers the housing purchase to individual ‘mom-and-pop’ investors.
So in theory, negative gearing seems like a mutually beneficial arrangement. Investors remain financially solvent while growing their overall wealth. Governments are willing to trade-off high infrastructure costs for short-term tax deficits. But is it all that it is cracked up to be? More importantly, should you get into real estate investment solely for negative gearing?
When Is Negative Gearing Most Effective?
The true economic benefit of this tax benefit has some practical considerations. For starters, investors which fall under the higher tax brackets would benefit greater than investors in lower tax brackets. As an example, an individual that is taxed at 40% will have much more to gain in reducing his/her tax base, compared to someone that is taxed at 18%.
Finally, negative gearing can support those wishing to use real estate or similar income-producing assets to build their retirement plan. Say you start investing into real estate around 30, and are currently subject to an effective tax rate of 35%. As your costs are typically higher in the earlier years, negative gearing allows you to front-load your deductions. As you approach retirement, you will start to pay taxes on the property, however that is presumably at a lower tax bracket as your personal income would be lower.
How Can You Maximise Negative Gearing Benefits?
There are a few important areas to consider for optimising any negatively-geared benefit:
- Ensure the home value is on par or exceeds the land value: this goes back to tax basics. Land is not a depreciable asset, however buildings and fixtures are depreciable. Therefore, by maximising your home value, you are in turn maximising the costs available to be claimed as deductible expenses
- Location, location, location: building a house in a good location, particularly a good rental suburb, is critical for long-term growth. Owning a property in a neighbourhood that is close to schools, transportation and other amenities, is vital to ensuring stable tenancy. As your benefits from negative gearing diminish over time, they should be replaced with growing rental yields
- Purchase single-family over other housing types: Given the demographic of would-be renters, you can effectively maximise your odds of suitable tenants by purchasing a single-family dwelling, over an apartment or multi-level home.
While the above factors positively correlate with negative gearing benefits, they are also essential for long-term wealth creation. That’s the whole point. Owning rental properties with the intention of maximising tax savings is not a sustainable plan. While negative gearing plans are government-backed, it doesn’t mean they will be supported forever. Just recently, there were discussions by the Australian opposition party to completely overhaul Australia’s negative gearing system.
So if the intention is to enter into real estate investment for tax savings alone, I fear that any success will be short-lived. When I started investing in real estate, I benefited from the country’s negative gearing arrangement. However, if the arrangement were to change, I had sufficient liquidity to cover my property loss. There was still risk in my strategy, however I would not be underwater if the tax regime were to change.
What Are Some of The ‘Negatives’ of Negative Gearing?
Simply put, the opposite of the factors above are harmful to establishing a negatively geared portfolio. Purchasing older, established homes does not yield the most optimal negative gearing yield, as it’s likely that most of the property would already be depreciated. Furthermore, purchasing properties in exclusive suburbs, or suburbs with high rental yields, reduces the potential pool of available tenants as well as diminishes your future rental growth rate.
Let’s talk about when you eventually sell one of these properties. In Australia, selling a rental property for more than its purchase value will give rise to capital gains tax (CGT). While individuals receive a 50 percent CGT discount, this potential tax may erode some of the benefits you obtained through negative gearing. You may not be particularly bothered with this outcome (depending on your circumstances), but it is something to keep in mind.
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As a real estate investor, particularly a new one, you can avail yourself of a sizeable tax advantage during your real estate journey. Having access to negative gearing is certainly helpful in growing your property portfolio. However, I must emphasise that it should not be the sole reason for property investment.
Instead, one should first focus on sound financial hygiene practices and ensure that you have a comfortable level of leverage in case government-backed arrangements change in the future.
Hope the information above helps. Please let me know your thoughts in the comments section below.