Negative Gearing... Friend or Foe?
Often proclaimed as a property investor's best friend, negative gearing is a concept that few people really understand. Sadly this ignorance is causing many investors a lot of financial heartache.
Let's review the basics of negative gearing, the way it works and how unwary investors are being willingly coaxed to buy a so-called asset that's purposefully designed to lose money.
In his special article entitled 'Positive Cashflow Returns Through Property Investing', expert property commentator Steve McKnight rightly pointed out that there are two ways to make money in real estate. Either through capital appreciation, when your property value goes up, or via positive cashflow returns, when you have more income than expenses.
And in the world of property investing, the most common way that investors seek to profit is through capital appreciation, which is why location is regarded as critical to real estate success.
The preferred weapon in the fight to achieve capital gains returns in Australia, New Zealand and Canada is something called negative gearing.
Negative gearing seems simple enough - buy the right property in the right location and then have the tenant and the taxman partially fund your repayments while you sit back and profit from the appreciating property value.
But can using property to make money be that simple? In a rapidly rising market, as was seen in most of Australia between 1996 and 2002, yes - it can appear to be that easy. Just hop on the escalator and ride the easy way to the top.
Yet there quite are a few investing pitfalls that aren't discussed in the glossy sales 'off the plan' brochures, at the free seminars, or on the carefully tailored TV reality shows.
So let's take a full "warts 'n' all" look at negative gearing to see when to use it... and when to avoid it like the plague.
What Is Negative Gearing?
There's lots of hype when it comes to negative gearing. Lots and lots and lots in fact. And this all stems from the fact that quite a number of property sharks make a killing from selling negatively geared properties to unsuspecting investors.
Sadly, a lot of investors are sold on the potential outcome of owning property (hopefully making truckloads of money) without understanding the immediate consequences of their investment.
Negative gearing is a strategy that provides immediate tax benefits while also offering the promise of long-term gains in the form of capital appreciation.
The Australian Taxation Office (ATO) allows property investors to offset an income loss (where property costs are higher than property income) incurred on a real estate investment against any other income.
To explain how this works we need to work through the numbers based on a typical property (note: tax calculated based on 2003 tax rates).
John is a taxpayer earning $80,000 per annum (plus superannuation) in a contract job for a major IT company. He is thinking about purchasing a property for $230,000 (inclusive of $7,850 in closing costs). To maximise his available tax deduction he has been able to secure 90% finance on a 25-year principal and interest loan with a current variable interest-only rate of 6.7% per annum. He makes weekly loan repayments in advance. The developer has offered a 5 year rental guarantee at $250 per week. The rates and body corporate fees total $2,000 per annum and there's also an 8% rental management commission to be paid. We are going to ignore depreciation benefits for the time being. At the end of the first year, the profitability of John's property investment would be:
John is then able to claim the loss of $3,909 against his salary income and can reduce his overall tax bill as follows:
|Property tax loss||-||($3,909)|
|Tax + Medicare||($26,180)||($24,284)|
Even though John has made a loss of $3,909, the after-tax effect on his bottom line income is only $2,013 ($53,820 - $51,807).
Are you wondering that given this investment was going to lose money, then why on earth would John want to buy it?
Good question! Trying to explain a good answer raises several key issues at the heart of negative gearing that must occur before you'll make one dollar in profit.
The short answer is that John is speculating that his potential capital gain will be consistently more than his certain income loss.
Which isn't out of the realms of possibility given that all he seemingly needs to make is capital appreciation of just 0.88% ($2,013 / $230,000) per annum to at least break even.
Indeed, if John had've purchased this property back in 1996, then it's extremely likely that he would be sitting on a small gold mine right now.
But trying to examine John's intention for investing actually opens up many other issues that must also be considered to paint the full picture of his investment - now and in the future. Let's now examine some of those issues...
Can you make money and save tax at the same time?
At any given point in time you can't make money AND save tax because the act of making money gives rise to the need to actually pay tax.
This is where we need to discuss the difference between a realised and an unrealised profit/loss.
In negative gearing the loss is real in that John will physically have to come up with the after tax shortfall of his expenses over his income. This can be summarised by:
|Tax benefit @48.5%||$1,896|
|After tax loss||($2,013)|
The consequences of this are that John will physically lose the buying power of $2,031 out of his pocket until expenses fall and / or income rises. In pre-tax dollars, the $2,013 equates to 5.19% (($2,013/48.5%)/$80,000) of his salary that he has lost from owning this property.
On the other hand any of his capital gains remain unrealised, and as such there is no tax to pay, until he decides to sell.
John can even refinance any capital appreciation he obtains and effectively pay no tax provided he doesn't sell!
But the problem with an unrealised gain is that you can't generally use it to fund your lifestyle. For example, you can't go into the supermarket and pay for your groceries using your capital gains debit card.
Accessing your unrealised profits can also be expensive (with redraw fees) and time consuming (with forms to fill in and sometimes lengthy delays).
Contrast the situation of realised loss and unrealised gains (as discussed above) with cashflow positive property that has only realised income gains.
Because your property income is higher than your property expenses then you'll have to actually pay tax on your profit.
For example, imagine John purchased a property that had the following annual outcome:
|Tax payable @48.5%||($970)|
|After tax profit||$1,030|
Unlike the previous negatively geared example, if John purchased this type of property then he'd instantly add to his bottom line. That is, he'd have more money from investing in property from day one (before any capital gains) not less.
And under both models he would profit from any capital gains although it has been traditionally claimed that it is difficult to get both capital gains and positive cashflow from the same property.
The bottom line here is that it's not possible to use negative gearing to consistently invest in property in a way that sees you pocket more cash AND claim also claim a tax deduction at the same time.
How many properties can you afford to own?
Statistics show that only 1 in 200 property investors own more than 5 properties. But if owning property was such a great idea then wouldn't it make sense to own multiple properties... say 10, 20, 30 or even more?
The reason why only 8% of all investors are able to own 3 or more properties is because of an affordability issue.
Let's go back to our earlier example and imagine that John was able to buy 5 of the same negatively geared type properties. How would his after-tax financial circumstance look then?
|Property tax loss||($3,909)||($19,545)|
|Tax + Medicare||($23,711)||($16,230)|
What we can see now is that as John owns more properties his after-tax cash position is dramatically shrinking. Sooner or later John will reach the point when he can no longer afford to buy more property. His real after-tax wealth is reducing in ever decreasing circles, which is illustrated in the graph below.
The graph above shows that as John owns more property his after tax available cash decreases, while his losses from owning property increases. This illustrates the decrease in his purchasing power as only a maximum of 48.5% of the property loss can be claimed as a tax deduction. The remainder must be paid out of John's after-tax salary.
The lack of sustainability is a phenomenon of negative cashflow that is rarely discussed.
The outcome of this investment is that you need to keep working in order to continue to earn enough of a salary to fund the cash drain of the loss making investment.
Five years on...
Let's take our example of John a few steps further and fast forward five years. His property has appreciated by 40% and is now worth $322,000.
His rent has increased by 10% and he now earns $275 per week, but his rental guarantee has now lapsed and he needs to allow for $1,000 per annum in maintenance. Rates have risen to $2,200. Let's imagine interest rates have remained steady at 6.7%. During the same time John's salary has risen to $90,000.
His annual property income statement would now look like:
Based on these figures John's property has been able to hold it's own in terms of profitability in that his rental increase has offset his additional expenses. Really though, allowing for inflation, he is slightly worse off as a dollar five years on buys less than a dollar at the time John bought his property.
|Property tax loss||-||($3,913)|
|Tax + Medicare||($30,457)||($28,559)|
Whereas five years ago John was $2,013 out of pocket, now he's $2,015(58,970 - 56,955) a minuscule deterioration.
But he has earned unrealised capital gains of $92,000.
In summary on paper he's doing well, but in reality his purchasing power has taken a hit. Negative gearing has achieved an outcome of theoretical wealth-creation but an actual real loss in purchasing power.
Using the equity
But John has made a paper gain of $92,000. If he decided to realise that gain, what options does he have?
Assuming John sold his property for $322,000 on the last day of the tax year then his profit would be:
Sales price $322,000 Agent's commission (4%) ($12,880) Legals etc. ($2,000) $307,120 Acquisition Cost ($230,000) Gross Capital gain $77,120 50% Exemption (Note 1) ($38,560) Taxable portion $38,560 Income Tax at 48.5% ($18,702) After Tax Profit $19,858 Add Tax Free Portion $38,560 Total After Tax Gain $58,418True After Tax Gain Total Gain $58,418 Five Years (After Tax)
($10,065) Nett Gain $48,353
My point here is that John's paper gain of $92,000 is quickly eroded back to $48,353 after adjusting for tax and the negative cashflow. Perhaps it's pertinent to remember that tax is only payable if you sell, in which case the impact on your net profit can be significant.
If John sold his property under this circumstance then he would have made a decent return, albeit he would have had to take a lifestyle cut in order to fund the annual negative cashflow from expenses being higher than income.
Hold and refinance
If John didn't want to pay tax then he needn't sell. He could approach his original financier and seek to refinance his loan to 90% of the new value. That is, he could access a further $82,800 (90% ($322,000-$230,000)).
Should John use this money for investing in other property investments then he would qualify for a tax deduction on the additional interest. But if he did this then his annual negative cashflow would increase because he has borrowed more money.
It would now appear as:
Rental income $14,300 Rental Management ($1,144) Loan Interest (90% of $322k) ($19,417) Rates etc. ($2,200) Maintenance ($1,000) Total ($9,461)
What John would find is that refinancing would allow him to acquire another property with no money down, but the additional interest cost would further reduce his after-tax available cash.
But the worst thing that John could do is redraw the equity and then fund his lifestyle with the proceeds. If he does this then he will lose the interest deductibility of the redrawn amount - which will have a nasty impact on his overall wealth creation.
Let's look at what would happen if John redrew all of his equity and funded a round-the-world extravaganza.Rental Income Statement If John
Refinances And Spends Money On Lifestyle
Rental income $14,300 Rental Management ($1,144) Loan Interest (Note 1) ($13,869) Rates etc. ($2,200) Maintenance ($1,000) Total ($3,913) John with
Salary $90,000 Property tax loss ($3,913) Taxable income $86,087 Income Tax + Medicare ($28,559) Subtotal $57,528 Non deductible interest ($5,548) Nett Cashflow $51,980
Note: The total interest would be ($322,000*90%) * 6.7% = $19,417, however on the portion relating to the property investment ($13,869) would be deductible. The remainder ($5,548) is not deductible as it relates to private rather than investment expenditure.
The wash up of all this is that if John sold then he would pocket a handsome gain - the product of steady capital appreciation while he owned the property.
But if he refinanced and then invested the proceeds then his borrowings would increase, as would his interest costs, which would have the effect of further decreasing his nett after-tax available cash.
Even worse, if John refinanced the property and then took his equity and spent it he would be left with an interest bill that was not deductible. He might just as well have applied for a personal loan. Investors should never drawdown on equity to fund a lifestyle. It would be better for John to sell and pay for his trip as at least he would have borrowed the money but would have used realised profits.
It's just assumed that you'll make money from buying a negatively geared property, provided you can hold on for the long-term and wait for the escalator of property prices to steadily rise.
In times of rapidly rising prices this is great, but in times of stagnant or even falling prices then negative gearing is a poor strategy.
It's true that you won't lose unless you sell... if you can hold on for the long-term and ride out any bumps then you should do well because property prices generally trend upwards (meaning that the average property will increase in price over time.)
The real losers are investors who buy in the boom and have to sell in the gloom because they can't afford to ride out the storm.
If John had've purchased five properties and interest rates rose from 6.7% to 10% then the result would have been disastrous. His after-tax remaining cashflow would be:
Rental Income Statement: John With 5 Properties And Interest Rates Rise to 10%
|Property tax loss||($53,740)|
|Tax + Medicare||($7,594)|
Ouch! John's available cash has just about been crunched. It's no wonder so many property developers went to the wall when interest rates spiked at 17% in the early 1990's.
Assuming that interest rates will remain low or that property prices will rise forever is nothing more than a fairytale assumption that is really the best case scenario.
The Seven Negative Gearing Truths!
Truth #1: Negative gearing is a strategy guaranteed to lose money
A negatively geared property is designed to enable you to access an immediate tax deduction arising from the shortfall of rental income failing to cover your property expenses.
In other words, negative gearing is a strategy guaranteed to make a loss.
In order for you to afford this loss, you'll have to fund it out of your existing cash flow by working longer hours, or by taking a lifestyle cut. For most people this means going without some of the luxuries they previously enjoyed.
No one wants to lose money, but it is testimony to the power of effective marketing that smart investors are fleeced out of thousands of dollars by being conned into a concept that only exists to lose money in the short term.
The only way an investor can make money from negative gearing is if any potential future capital appreciation is higher than the certain cashflow loss incurred today.
Negative gearing is a valuable profit-making tool in a rising market. But it is not a strategy for all investing seasons.
Truth #2: The dangers of depreciation
Buying a property based on depreciation benefits is dangerous and deceptive.
Depreciation is an accounting term used to describe the wear and tear of an asset that occurs over time. In practical terms, depreciation on a property refers to the carpet wearing down, the walls becoming chipped or stained and the furniture dating.
In most new properties you are allowed to claim a tax deduction for the depreciation of the fixtures and fittings and in certain circumstances you may also claim a building write-off of either 2.5 per cent or 4 per cent of the property (not land) value too.
Slick marketing companies sell the notion of the taxman paying off your property using depreciation and building write-off deductions, but this sales pitch is quite deceptive because you don't avoid paying tax with depreciation, you just defer it.
Commonsense suggests that depreciating an appreciating asset like property will give you a tax deduction today, but you'll have to repay it in the form of capital gains tax at a later date when you sell.
'Bracket-creep' issues can catch out many taxpayers too. If you earn $50,000 when you buy the property you will only be able to claim a deduction for depreciation at 43.5 cents in the dollar, but if your income rises to $60,000 when you sell then you'll need to repay the depreciation at 48.5 cents in the dollar.
If you don't ever plan to sell the property then at a minimum you should recognise that your depreciation tax deduction represents the wear and tear on your asset that will need to be eventually refurbished in order to continue attracting quality tenants.
Finally, beware any financial model that allows for depreciation benefits but does not include a maintenance budget. You cannot have depreciation without an expectation of repair costs - even new properties still need tap washers replaced.
Truth #3: The deception of attracting premium tenants
A common strategy used to sell negatively geared property is to focus on purchasing a blue-chip property that will attract a premium tenant, since a premium tenant is more likely to be a quality long-term and high paying occupant.
Yet my experience reveals premium tenants are often the most volatile segment of the rental market. When times are prosperous, then premium tenants look for glamorous living in the newest kind of accommodation available with all the modern conveniences.
But when the economy contracts, premium tenants with high paying salaries are at a high risk of being downsized. If this happens, then they will seek cheaper accommodation leaving investors owning expensive property competing for new tenants in a shrinking market.
In times of serious recession it's not unusual to expect vacancies of three months or more on premium property, which can make owning negatively geared property an absolute investing cashflow disaster.
A better strategy would be to attract a quality tenant who is willing to pay between 10 and 20 per cent above the market rate for a well-maintained property and decent landlord service.
There will always be demand for a house that the average family can afford to live in. It would be wise for you to focus your attention on purchasing a property that is less prone to market fluctuations, and then seeking to charge above market rates for a quality property to attract long-term tenants that want to treat your property like a home.
Truth #4: Unfair comparisons
Figures used to substantiate expectations of appreciating property values are in many instances downright deceptive. One common example is the rise in the value of median property prices being applied to premium real estate market.
In reality property prices can rise and fall in the same market at the same time. To eliminate this variance, statisticians adopt a mathematical snapshot of the market based on the value of median property sold during the period.
Movements in the median property price are certainly not representative of movements in the highly priced end of the market. Attempts to correlate movements in the median property values to highly priced real estate is statistically incorrect at best and potential fraud at worst.
Making an assumption that real estate values double every seven to ten years, across all types of property (houses, units, etc.), in all States, is misrepresentative.
It's very easy to build a financial model and then hide distant reality in broad assumptions or leave out important information all together. For example, making no allowance for vacancies after the rental guarantee period has finished or showing after tax nett profit with no allowance for capital gains tax payable when that asset is sold.
One quick way to test the conviction of a sales agent promising capital appreciation is to get him to personally guarantee it in writing. Given the degree of their certainty about rises in property value and considering the massive investment you'll need to outlay to own a blue chip property, a written guarantee simply confirming the underlying assumption isn't too much to ask.
Be very wary of the assumptions used in any financial model.Truth #5: Who's really paying for the secret commissions?
If you liked the idea of purchasing property similar to the one that John purchased then you're probably asking 'Where can I find such a property?'
Enter the free seminar circuit, which is often little more than an elaborate attempt to sell you an over-priced property that meets the finely-tweaked financial models devised by clever marketing agents who are paid a commission to sell real estate on behalf of developers.
It's not unusual for commissions to be five per cent of the sales price, which on the property used in the earlier example amounts to $11,500.
This fee is not paid from the developer's margin. It's a cost added on top and paid for directly by you the purchaser. It can become unnecessarily expensive buying prime property off the plan when there are kickbacks to financiers, fit-out providers and sales agents all funded by you as the purchaser.
Negative gearing is often sold as a strategy that will make you rich in the future, but when you buy a boutique property you'll be making developers and sales agents rich today. Be very wary about letting other people profit at your expense.
Remember to always ask 'Who gets paid when I buy?'
Truth #6: The trap of trying to save tax!
One of the many sales reasons given for investing in a negatively gearing property is that qualified accountants recommend it.
Indeed, if you approached most accountants and asked for strategies that legally minimised tax then negative gearing would be one of the first options discussed.
But investing in negatively geared property to save tax is a double-edged sword. For every dollar you lose, you'll only ever recoup a maximum of 48.5 per cent back as a tax saving.
While you're waiting for illusive capital appreciation you'll be working longer hours and trying to cut back spending in order to fund the continual cash outflow when your property expenses are always higher than your rental income.
If you are paying your accountant for advice then spend your money searching for strategies that will earn cash profits, not ways that are guaranteed to make a loss.
You might pay more in tax but you'll also be earning much more cash profits too.
Truth #7: How many of these properties can you afford to own?
As you own more negatively geared property, your after-tax available cash reduces. This is because you only ever recover a maximum of 48.5% in a tax deduction, the remaining 51.5 cents in the dollar comes from your back pocket.
It makes sense that as you own more loss making property your real buying power shrinks in ever decreasing circles.
The Final Word
The general PropertyInvesting.com community is not totally anti-negative gearing.
It's a proven wealth-building strategy during times of rapid price increases provided you can comfortably afford the negative cashflow and are happy to continue working.
But as the saying goes... 'horses for courses'.
Negative gearing is a strategy designed to lose money and in order to fund that loss you will need to continue working. This makes the strategy at odds with the broader target of financial independence. If your goal is to stop working as soon as possible or to free up more time to do the things you love, then negative gearing is not a wealth building strategy you should implement.
Remember that there's a lot of hype about negative gearing because a huge industry of developers and sales agents make a living by selling property. It's more important than ever that you complete a proper due diligence over a potential property purchase to ensure you can afford the ongoing cash outflow from your property.
Be very careful about blindly purchasing any kind of property.
Be extra cautious when buying something when the outcome is likely to be negative cashflow.
Be extremely careful when buying property that a sales agent or a developer says has tax advantages... this is a red flag that the property is guaranteed to lose money.
Making a profit from speculating that property prices might rise while you incur a certain income loss is risky.
Remember that if all you did was make money, then you'd have to make money. If your investments are not making money then something's going badly wrong.
The Nine Questions To Always Ask...
- What's the end purpose to my investing?
- Will buying this property bring me closer to, or push me further away from that goal?
- Am I saving tax or making money?
- What is the annual cash in or outflow?
- Can I afford to make a sustained loss?
- What is my exit strategy if things get tough?
- What has to happen in order for my property to make money?
- How many of these properties could I afford to own?
- Have I checked and double-checked all the figures and sought independent information to ensure the data I have is realistic?
Please note that depreciation benefits have not been discussed in this analysis of negative gearing since it was assumed that the property that John purchased did not attract any depreciation. However, this is an important area that is discussed on an investor briefing titled 'Depreciation - Investor Delight Or Extreme Danger? '