Many people in Australia use negative gearing to build long-term wealth.
It is, however, not without risks, and it is critical to understand how it works before embarking on this journey.
In this post, I’ll focus on using negative gearing to purchase investment property, however, many Australians also use it to buy shares.
What is Negative Gearing?
The term “gearing” refers to borrowing money for the purpose of investing.
If the expenses associated with that investment exceed the income received, then the investment is negatively geared.
Positive gearing, on the other hand, is when the income exceeds the expenses.
Why Investors Use Negative Gearing
Investors use Negative Gearing to purchase assets to not only generate income, but importantly, to enjoy longer-term capital gain.
Another factor is the favourable tax treatment that could arise if the expenses associated with maintaining the investment, exceed the income in a given year.
When this happens, the loss is usually deductible against other income for tax purposes.
In the simplified example above, if an individual earns $150,000pa and had no other deductions, then in the 2022 year, they will pay tax of $43,467.
However, if he/she possessed investment properties that generated rental income of $52,000 and the total expenses were $72,000, the resulting loss ($20,000) may be offset against his/her income for the year.
The loss ($20,000) reduces his/her Taxable Income to $130,000, decreasing the tax liability to $35,767, a tax saving of $7,700.
A key point to note is, that whilst the tax paid has been reduced, because of the Rental Loss, Net Income After Tax is reduced by $12,300 – which needs to be met/funded.
Note – from a cashflow perspective, if you know an investment will result in a tax loss over a year, you can apply to the Tax Office for a PAYG Withholding Variation and reduce the amount of tax taken out of your salary.
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