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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.
Negative Gearing Example
Without Investment Properties
Net Income After Tax
With Investment Properties
Net Income After Tax
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.
What Expenses Can Be Offset Against Income Generated?
In most cases, the costs of maintaining an investment can be offset against the revenue it generates in a given tax year.
This can include items such as:
More information is available on the ATO website.
Note: Money spent on upgrading the property (extensions for example) are depreciated over a longer term, depending on the type of construction and when it took place.
Capital Gains Tax
Any capital gain from the date of purchase is taxed at your marginal rate if you sell the asset.
However, if you hold the investment for more than 12 months, only 50% of the capital gain is taxable.
Seek Professional Advice - Understand How it Works
While, as previously indicated, many people have employed negative gearing to build long-term wealth, it is not risk-free.
Before venturing down this path, it is important to:
Seek professional advice from your Accountant and/or Financial Planner
Ensure you understand all the implications associated with negative gearing and capital gains. This should include what can be claimed and when, and also what can’t be claimed.
Understand how Lender’s approach Investment Finance (I can assist you here)
Other Critical Factors to Consider
Renting Out Your Home
For a variety of reasons, some people may choose to rent out their home and treat it as an investment property.
Before taking this step, as with any other investment, speak with your accountant to fully understand the ramifications.
(If you rent your home for more than 6 years, you may be subject to Capital Gains Tax when you sell it)
Negative gearing should always be part of a considered, and well-planned, wealth creation strategy.
While the tax advantages negative gearing offers will be a factor, it should not be the primary driver.
The quality of the assets you purchase to produce income and longer-term capital gains should be the primary considerations.
Before venturing down this path, it is important to do your research and consult with professionals such as you’re Accountant and/or Financial Planner
If you would like to learn more, or to talk about financing investments, don’t hesitate to get in touch.