Tax Tips/Strategies #3 | The Most Exhaustive & Comprehensive Guide to Artificial Negative Gearing
Updated: Nov 4, 2021
The Most Exhaustive & Comprehensive Guide to Artificial Negative Gearing
Many investors benefit from tax deductions (sometimes negative gearing) without even knowing it, especially if you have more than one property because most people are just concerned about the final number (whether you will end up with a tax refund or not). If you have lodged a tax return on your PPOR (debt recycling), there is a higher chance that you have already benefited from it. This is because this property was not originally bought with the intention to make a rental return but because it is a place and area you want to live in which can usually mean that the rental yield is low. Obviously there are some people, especially higher income earners buying properties with the sole purpose to reduce their tax obligations. Losing one dollar to save 40 or 50 cents is not something we recommend doing intentionally. In most cases, negative gearing usually results from the combination of several tax deductions such as depreciation on the property or the cost of keeping the property. It is this depreciation that sets the scene for the artificial negative gearing because it is a tax deduction on an non-cash component that you cannot control. It can be significant enough to turn a slightly positive geared positive, negative without any additional investment/expense especially if it is a brand new property.
Whichever the case may be, negatively gearing your investment property will help you offset your taxable income, especially when used in combination with tax strategy 1 and 2. As always, please seek a tax professional when considering using any of my tax tips/strategies.
Negative Gearing Explained
Gearing is used when referring to borrowing with the aim of investing in an asset, whether it’s a property or anything. However, when viewed in terms of property, it is used in describing the act of using a loan to purchase a property. Therefore, gearing an investment property implies that the property does not provide enough rental income to equal the interest paid on loan. The effect of this is a loss.
Negative gearing differs from positive or neutral gearing. In Neutral gearing, the generated rental income is equal to the interest paid on loan, while positive gearing generates more rental income compared to the interest paid, thereby resulting in a profit.
Some of the expenses on your investment property include:
Property management fees
Landlord and building insurance
Maintenance and repairs
Strata fees, council rates, and land tax
Here’s a brief illustration to help you understand negative gearing a lot better.
Assume that you took a loan of $250,000 with an interest rate of 10%, and this was after you bought a house worth $300,000. The interest that you’ll repay on this house is $25,000. However, you only earn $200 weekly in rent or $10,400 annually.
With this, you’re earning $10,400 in rent and paying an interest of $25,000 annually, meaning that you are losing $14,600 per year. This shows that the house you bought is negatively geared. It is important to note that this can be the case with any other investment property.
Following this perspective, you’ll agree that negative gearing is similar to other business activities with only income and expenses regardless of their source.
Negative Gearing Policy
The main reason why people venture into property investment is to enjoy long-term capital goal. However, this might be somewhat different, especially if you are aiming for a competitive real estate market. You may need to go as far as sacrificing your rental yield and even incurring a loss on your property.
What is generally expected is that as the price of the property increases rapidly, there’d be a corresponding fall in the rental price. Therefore, investors can use this to make money rather than depending on the income that they generate from rental payments. Ex-PPOR owners can also used this too given the fact that you likely bought (potentially overpaid for it) in a more desirable location that have higher potential of capital growth, or at least get something back for the property you can no longer live in for whatever reason.
Negative gearing in Australia usually attracts tax benefits on the shares investment and the property. This implies that for an investor that loses money as a result of loan repayment, the loss can be written off yearly as a tax deduction. This is an simple way to reduce taxable income and also make up for the losses they experience.
For the example we highlighted earlier, the taxable income of the investor will not include the $14,600 yearly loss. Therefore, your taxable income is $100,000; negative gearing would make it possible for you to reduce the amount to $85,400. If you use this calculator you will see the difference in tax paid for either taxable income amount and note that you will save ~$5,500 in tax which immediately shows that losing ~$15k to save ~$5.5k is not a wise investment decision. It may be worth doing if it’s from depreciation only or better than nothing if you are no longer able to live in your property anymore.
There are so many other tax policies that can be used with negative gearing. An example of this includes depreciation claims, and the aim is to create a balance between profit and loss yearly. If the negative gearing is significant enough, it can cause the deficiency in rental income to become insignificant.
Reasons to Choose Negative Gearing
Everyone is aware that owning a house (over townhouse/apartment) as close to a CBD as you afford is a reliable way to get profit and long-term capital growth on an property. However, the major problem is that getting such properties is not always as easy as it may seem.
In most cases, investors are usually forced to forfeit short-term rental income when they try to secure a property that can ensure them long-term capital growth in the long run. Also, some investors usually resort to the negative gearing strategy.
Investors often come to the conclusion that making short-term sacrifices is sufficient enough to achieve their long-term increases. This is the main reason why investors include the negative gearing strategy in their investment plan.
While this may seem an effective strategy, one thing you should always note is that the purpose of negative gearing is not to be used as a long-term investment strategy. It is designed as a way of helping investors to ease their burden as they continue to pay the outstanding on their investment property. The goal is to get to the point where the investment property is positively or negatively geared.
Many factors can trigger negative gearing. It could be triggered when rental payment cannot cover expenses or even in an environment with high interest rates. It can also be triggered in cases where capital expenditure or depreciation magnify loss. One of the benefits of negative gearing is that you can offset a value of the net loss against taxable income.
For instance, assuming your income is taxed at a rate of 20%, your contributions to negative gearing will save you $0.20 for every dollar. Even though negative gearing has its own downsides, individuals with high income can enjoy the tax benefits it offers. Having negative gearing on investment won’t make much difference if you are earning and not paying tax or paying very little tax.
Understanding How Depreciation Works with Negative Gearing
Negative gearing is one of the most debated topics in the property industry, and it usually becomes more so during election time. It is an investment strategy that is widely used by many investors. We have already explained negative gearing, so we continue with depreciation.
Depreciation can be referred to as a complete decline in the worth of an asset, structure, or investment. One interesting thing is that this can be claimed as tax deductions yearly, which is an advantage for property investors. Depreciation can either be a property depreciation or a bonus depreciation. In the case of property depreciation, it is used in describing the wear and tear of an asset or a structure, while for bonus depreciation, it is used in describing a non-cash deduction. With this, investors can claim the deductions without spending a penny.
There are generally two categories for claiming depreciation. First is the capital works deductions which are for the structural component of the property, including most sinks, windows, and walls. The other category is for equipment and plant deductions, and this is for assets that can be easily removed, an example of which include hot water systems, ceiling fans, and carpet. With these two categories in place, there’s no limit to the type of depreciation that an investor can claim.
It is important to note that depreciation is a non-cash deduction, and this means that any property that is positively geared can be converted to a negatively geared property through depreciation. This is the reason behind my coining of the term, Artificial Negative Gearing.
Here’s how it works:
So, for instance, Frank earns $30,000 yearly with a tax of around $6,500 and a rental income of $10,000. The tax-deductible of his property will include maintenance cost, council rates, interest repayments, property management fees, and insurance, all of which is around $8,000 yearly. However, he has a positive gearing on his investment property which is around a $2,000 return.
Adding depreciation to this, Frank can claim his deductions, including equipment, plant, and capital works, which totals to $4,000 yearly. With this in place, the positively geared property become negatively geared, with a loss of $2,000 yearly.
Tax Depreciation Schedules
There are so many tools that can help investors to maximize their returns effectively. However, of all these tools, one of the most significant still remains under-utilized. What’s more, is that many still don’t realize how beneficial this strategy will be for them in the long run. Interestingly, studies have revealed that with the depreciation schedule in place, landlords can comfortably claim up to 40% of the value of their items. A depreciation schedule is what you need to make a difference and get an improved cash flow.
Are you wondering what exactly is a depreciation schedule and how an investor can benefit from it? We’ll cover these points in the next few sections below, so read one:
One common thing about items is that they lose value with time as a result of wear and tear. This implies that such items depreciate with time through wear and tear. Interestingly, investors can claim this decline as a tax deduction, thanks to the Australian Taxation Office (ATO). As we have mentioned earlier, this is a non-cash deduction, and this means that investors can claim it without spending a penny. That is the main reason why most people opt for a depreciation schedule, which might cause them to miss out on some tax benefits.
How it works
To get a tax depreciation schedule for your property, you need to know that it will be split into the two categories we have mentioned earlier. First is the capital works (division 43) that comprise the backbone and support for the depreciation schedule. It covers the wear and tear of the structural components of a property and items permanently fixed to the building, in addition to other miscellaneous, like renovations, structural improvements, extensions and more. It is best to check with an accountant whether any works you want to complete constitute as capital works (although that wouldn’t be considered an artificial depreciation!). If the property is constructed from 15 September 1987, it will generalyl have an effective life of 40 years. The rate that can used to depreciate the building depends on a few factors and can be seen in the following figure.
You can claim these tax deductions if it’s an income producing asset.
The second category is the equipment and plant (division 40) category, which we have mentioned earlier, and it consists of temporary assets, all of which are removable. This includes flooring, carpets, appliances, and furnishings. The ATO has set out the effective life for many of these items. Eligible items can qualify for an immediate full deduction if they cost $300 or less.
New rules have come in for all property investors. All previously used items acquired after 7:30pm 9 May 201(unless contract was entered into before this); items acquired before 1 July 2017 but not used to earn income in current or previous year.
It is worth mentioning that only properties that were built after July 1985 can quality for both types of deductions for residential property investors. However, for the equipment and plant categories, you can make a claim on the property even if it was built before this date. What’s more is that the savings for older properties can be significant (depending on the age of the property can be the second largest after loan interest).
To make a claim of the depreciation schedule, you need to know how to identify all the parts of your property and know how they’ve depreciated. The aim of the tax depreciation schedule is to provide a summary of this information and give a clear idea of what you can claim. You’ll need a Quantity Surveyor to inspect your property if you want to complete this report in a format your accountant will accept.
With tax depreciation schedules, you can improve your cash flow significantly, and it will also help you reduce the amount of tax on your property.
Getting a Depreciation Schedule
Are you wondering when is the right time to order for a depreciation schedule? In general, the best time to get a depreciation schedule is towards the end of the financial year, which is usually around June 30, and the aim of this is to ensure that you maximize your returns. This implies that when you get the depreciation schedule before this time, you’ll be able to claim all you are eligible for, including those from the previous financial year if applicable.
Another key thing to note about the tax depreciation schedule is that they usually come with a one-off cost, which usually lasts up to 40 years or the life of the property. This is to ensure that owners and property investors make the right claim of their properties. Fortunately, this is a tax-deductible cost. It usually cost ~$700 per property (tax deductible) and the company generally is happy to add items to the report at least once per year without extra cost.
This goes to show that when you get your depreciation schedule before June 30, you can make the most of your cash flow all year round. Getting the schedule earlier is a way to claim the fees and ensure that you maximize your returns.
Whether you just acquired an investment property or not, you can still get a depreciation schedule, but it is important to do this before the end of the financial year instead of waiting for the next financial year.
Depreciation and capital expenses and allowances
Deducting spending on a capital asset immediately is not always possible, but what you can to claim it over time as the assets declines in value. A depreciating asset has a limited life which is why it is expected to decline over time as it is used.
Here are some things you should know:
Temporary full expensing
A business with a turnover below $5 billion can deduct part of the eligible cost of the depreciating asset immediately. For corporate tax entities that do not meet this turnover can still benefit from temporary full expensing, but this will through an alternative test. Also, the eligible asset must be used for a taxable purpose within the next two years.
For larger businesses in which the turnover is below $50 million, the temporary full expensing can also apply.
Instant asset write-off
The asset write-off for assets purchased within this financial year and ready for use till the end of the next financial year include:
- Eligibility range: Businesses with turnover between $50 million and $500 million.
- Threshold: $30,000 to $150,000
Backing business investment
This measure provides up to a 15-month investment incentive as support for economic growth and for business investment. The aim is to accelerate depreciation deductions. Here are the features of these incentives:
Businesses eligible for this are those with an aggregated turnover that’s not more than $500 million.
For new depreciating assets, you must first hold, use, and install the asset for a taxable purpose before the end of the next financial year. However, there are some exclusions that may apply to this.
For investors who do not want to apply the business investment to their assets, the option to apply the general depreciation rule is also there.
General Depreciation Rules
Depreciation deduction for assets is classified by using the general depreciation rules. The exception to this is if you are eligible for the simplified depreciation, which is for small businesses. With this rule, the amount you can claim is clearly stated, which is based on the effective life of the asset.
Here’s the write-off that can apply under the general depreciation rules:
- Items worth more than $300 which are used in earning income that’s not from the business
- Items worth $100 which are used in earning business income
Simplified Depreciation Rules
This is perfect for small business, and they can decide to use this rule, including the instant asset write-off.
Other Depreciation Rules
There are other rules that you need to be aware of, and these rules apply differently, especially to:
- Capital works which are written off for a longer period compared to other assets that depreciate
- Business capital expenses like the cost of ceasing or starting a business and project-related expenses.
In general, only legal asset owners can have access to the depreciation deductions. However, there is a slight difference for hire purchase in which the hirer is treated as the legal owner of the asset, making them eligible for the deductions. In the case of a partnership asset, the individual partners can claim the depreciation deductions.
Whether you are a hirer, a business owner, or an individual partner, you need to know that the depreciation deduction is limited to how you use the asset to make money. Therefore, if you use the asset for 55% business and 45% personal use, then you can only claim a total depreciation of 55% yearly.
Pros and Cons of Artificial Negative Gearing
Capital Growth: A vast majority of Australia’s properties will be negatively geared, and if you opt for negative gearing, you will get the opportunity to choose from different properties. For investors who know the market well, they’ll be able to choose from areas with high capital growth.
Artificial Negative Gearing: Enjoy the benefit of negative gearing without actually losing money, converting a slightly positively geared property to negatively geared.
High Depreciation: There are many properties with high depreciation, and you can look through them. You can also depreciate the building (especially if new) itself, as well as the internal fixtures. With this high level of depreciation, you’d get a tax break which you can claim.
Tax Saving: With continued market fluctuations, your tax deductions will become less than your taxable property income. Investing in a negatively geared property can offer great tax benefits.
Greater tenant diversity: You are able to use the tax deduction to help you keep competitive in the rental market to lure better quality tenants if necessary.
Opportunity to buy in better located areas: Let’s face it; high growth, desirable, nice and safe areas does not come cheap. This means that you may need to employ a number of different loopholes (First Home Owner Grant, Six Years of Absence, Debt Recycling) including (artificial) negative gearing (that may quickly become positively geared) to make the blow significantly softer to enjoy larger long term capital gains.
Opportunity to develop: Following from the point above, you are more like to buy a development asset with greater potential for capital gains rather than to wait years and potential a decade or more before your positively geared property can be developed.
Cash Flow: Negative gearing might not be a great option if you don’t have plenty of money even if it’s offset slightly by tax deductions. To keep a negatively geared property active, you’ll need to pay money on a monthly basis.
Capital Gains: Even though the capital gain is a benefit, it can eventually turn into a risk, especially for investors that fully rely on market fluctuations.
Serviceability: Depending on how you have negatively geared your property it can limit your ability to grow your property portfolio.
Regulatory risk: Policies are generally likely to be grandfathered but there is some risk that it could not which may force some people to sell before significant capital gains are realized.
Anytime is a perfect time to focus on ways to plan your tax in other to reduce risk, minimize tax and become financially ready. Tax planning is something that you should consider all the time because it can bring about a significant decrease in your tax liability. You need to know how to update or prepare a forecast of your spending and income because it will help your business easily identify when money is short and plan fast.
Artificial negative gearing is indeed a very useful tax deduction as you are not actually spending any additional funds and taking of advantage of the depreciation of your property that is already out of your control. This can make buying a brand-new property more attractive as an investment although you to balance this with the fact that it is likely significantly more expensive than an existing property for a smaller land size (component that rises over time) and potentially more like to have issues. It is also more difficult to find out previous issues if it’s not a strata property as these are likely to be reported in previous strata meetings that you can purchase. It’s helpful to think of it as a cherry on top among other benefits as the long-term capital growth tends to lag behind existing dwellings. In saying all this, the tax deductions (generally second largest after interest) can turn a slightly positively geared property to a negatively geared property and your taxable income is reduced in turn. Given the structure of a property have an effective life of 40 years, you can benefit for many years to come so it may be worthwhile getting a quantity survey to complete a depreciation report on your property. As with anything, this is a general article aimed for general consumption as there so many factors to consider to determine it’s financial viability, please seek your accountant when deciding on whether this works for your situation.
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