Negative gearing seems to have slipped off the radar in recent times, with the banking royal commission providing far juicier alternative headlines around topics like responsible lending and tightening credit policies, and what these are going to do to the property market.
But with a federal election due in the first half of 2019 (where Bill Shorten and Labor have touted a substantial winding back of existing negative gearing benefits) and a slowing property market-making conditions increasingly difficult for some investors, negative gearing is probably not too far away from coming back into the news headlines.
Benefits of negative gearing: Still a relevant money-making strategy?
Putting the potential political changes aside, is negative gearing as attractive an investment strategy in a slowing property market as it was when values seemed to be on an ever-increasing trend northwards?
Many people would probably think ‘no’, but probing into the details around what makes a good negatively geared investment can help us better answer this question for ourselves.
To make money out of a negatively geared property, an investor relies on the capital growth made on a property (their ‘sell’ price minus their ‘buy’ price minus any capital additions made along the way i.e. renovations) being greater than the cumulative net losses they incur while owning the property. I say net losses, because the loss on a property (i.e. when the income/rent is less than the sum of all expenses including loan interest, council rates, insurance, maintenance, etc.) needs to be adjusted for the tax benefit an individual investor gets by being able to offset this loss against their salary income.
Negative gearing example: Calculating net loss
An investment property with a $450,000 loan (and an interest rate of 5% p.a.) has a rental income of $400 per week ($20,800 for the year – assuming 100% occupancy for the full year).
Its expenses are $29,830 (loan interest – $20,250, Property Management fees – $2,080, Landlord Insurance – $2,500, Council Rates & Water Utilities – $3,500, and Maintenance – $1,500).
Therefore the loss for the year is $9,030.
The individual investor earns an annual salary of $110,000 – which is in the 37% income tax bracket ($87,001 to $180,000), meaning that by reducing their $110,000 income by the $9,030 property loss, they save $3,341 (i.e. pay $3,341 less tax).
So the ‘net’ loss to the individual (from the negatively geared property) is not $9,030 for that year, but rather $5,689 ($9,030 minus $3,341).
Negative gearing in a slowing property market
In a slowing property market, it can feel like you’re going backwards on a negatively geared property. While the capital growth on a property is largely influenced by the ups and downs of the broader property market, the investor still has a primary lever of control in the timing of the property sale.
So as long as the investor can afford to subsidise the cash flow shortage driven by the rental income being less than the combined expenses (the negative gearing), they still hold the ‘whip hand’ when it comes down to determining when they should sell the property to maximise the capital growth.
But the longer you hold onto a negatively geared property, the bigger your accumulated losses become (even with the individual tax benefits explained in the example above). So the timing around a negatively geared property investment is also critical. If you have to wait too long for the value of the property in question to go up (to create the capital growth), you may accumulate too many ‘losses’ to then make a profit when you sell the property!
The key here is to always have a handle on what your accumulated losses are (at any point in time), along with a rough idea of how much capital growth you might have achieved.
This information (combined with your forecast of what the property market is going to do in the short to medium term and your forecast expenses over the same time periods) will help you determine the best course of action around the timing of the property sale (and realisation of a profit or loss on the negatively geared property investment).
Does having a higher income help with negative gearing when the property market is turning down?
A slowing property market will mean different things to different people. Each property investor utilising a negative gearing strategy will also have their own unique set of circumstances relating to when they brought the property; how much they both paid and borrowed, the equity growth (or decline) they’ve experienced since buying it, the list goes on. And yes, while a higher salary income is going to mean a larger income tax offset (see example below) being achieved on the property investment, it is not a pre-requisite to achieving a good investment outcome from a negatively geared property.
The difference between the top two income tax brackets is 8% (eg. $90,001-$180,000 = 37% & $181,001 and over = 45%).
So a person on the top income bracket (45%) will save $800 more than someone in the next bracket down (37%) from a $10,000 annual loss via a negatively geared property (assuming the tax rates apply to all of the $10,000).
The higher income earner (in the example above) would accrue $4,000 of savings more than their peer on the 37% tax bracket over a 5 year period. The magnitude of this (income level) benefit could easily be surpassed in the end profit made on the negatively geared investment through factors such as negotiating well and purchasing the property at a discounted rate at the front end of the investment, or getting the timing of the property sale right, not to mention superior negotiating skills (when selling the property) to achieve a higher sale price.
Again the list goes on, and quite clearly, not being in the top income tax bracket should not dissuade someone from trying to make money from a negatively geared property investment strategy.
The importance of timing
A much bigger factor in the success of a negatively geared property investment (compared to the level of income tax offset) can be the timing of the ‘set plays’.
When I talk about set plays, think of the critical moments in an investment, namely both when you buy and when you sell the property.
Buying ‘well’ does not only mean purchasing in a period prior to future property market growth (and achieving capital gain over that period). It also refers to the negotiated price reached in the purchase, which could be influenced by micro-timing factors such as finding a buyer who is willing to sacrifice a portion of their potential sale price for the benefit of a quick sale and settlement.
Some of these abnormal factors can occur around arbitrary (but critical) time factors such as the end of financial year, or indeed the end of the somewhat unforeseen (and unfortunate) circumstances of a business or personal relationship breakdown. Achieving a ‘lower than market’ price in these circumstances is often viewed as getting some capital gain at the very front end of your investment.
Alternatively, at the back end of your negatively geared property investment (i.e. when you are selling), timing is also very important to the success of the venture. As recommended above, it is always prudent to have a good idea of where your investment stands ‘today’.
If you sold the property today, what would the profit be, taking into account the sale price you’d be likely to achieve (particularly after you’ve taken off your ‘rose coloured’ glasses), your purchase price and the accumulated net holding costs? Understanding this ‘position’, and how it might change in the context of the dynamics of the property market is also critical in helping you to choose ‘when’ to sell.
Savings.com.au’s two cents
Despite the threat of upcoming government-led changes to the rules around negative gearing, negative gearing can still be a valid strategy to employ in property investment. While a slowing property market (like the one we’re entering into now) certainly does change the dynamics of using this type of strategy, most would argue that it should not preclude it from being used.
Similarly, investors already employing this strategy in their property investment should not look at the changing market as a clarion call to exit out of their investments. Instead, they should consider their own individual positions by keeping a precise and up-to-date analysis on the details of their investment and make prudent decisions based around the balanced view that these and their clearly defined investment goals will provide.
This advice is general and has not taken into account your objectives, financial situation, or needs. Consider whether this advice is right for you. Consider consulting a qualified financial planner before making any financial decision and always read the product disclosure statement of any financial product.
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