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In the upcoming election there is a policy divide between the parties over “negative gearing” which  if one side wins, will only be able to be applied to brand new property.

To help you make sense of this let’s look at the whole issue –  what Negative Gearing is and why it matters.

What is an Asset? :

There are differing definitions of what makes something an investment but they all focus on two main points;

·       The ability to generate income.

·       The ability to increase in value.

In my opinion, the one to which the MOST attention should be paid is the ability to generate income because that is the most reliable indicator of something’s inherent financial value.

From this perspective something that generates no income is NOT as asset. This rules out many things often “said” to be assets. The most obvious here is a car. 

Let’s revisit purchasing an “investment” property. Let’s say this property costs $100,000 and we borrow it all. Let’s say it rents for $100pw so a 5.2%pa return

(if the property costs $200,000 and rents for $200pw, or costs $500,000 and rents for $500pw then the percentages are the same. Choose a value appropriate to your area – or just ignore the value and use my example.)

Let’s say the interest rate is 5.2%pa This would be a neutral return (ignoring inflation).

Let’s say the interest rate is 6.2%pa. This would generate a negative return of 1%pa – this is what people call “negatively geared” – in this example that loss per annum would be $1000.

Let’s say the interest rate is 4.8%pa. This would generate a positive return of 0.4%pa – this is what people call “positively geared”.

Negative gearing :

How many times have you heard someone say that negative gearing is a good thing? Is it? What does it mean?

Let’s put one thing to rest absolutely – losing money is a bad thing! Why would you invest to lose money.

There is an important point to understand.

Any real loss can CURRENTLY be deducted from your taxable income reducing the tax you pay. In the example above let’s say your income is $15,000 – your income would reduce to $14,000. You didn’t pay tax before and you don’t pay tax now. The whole $1,000 loss is yours.

Let’s say your income is $60,000 – your income would reduce to $59,000 and given that your tax rate is 30c you get a tax refund of $300 so $700 of the loss is yours. 

Let’s say your taxable income is $180,000 – your income would reduce to $149,000 and given your tax rate is 47c you get a tax refund of $470 so $530 of the loss is yours. 

What is the financial “lesson”? All negative gearing generates a loss.

Don’t take any notice of the refund – a loss is a loss.  NO investor tries to LOSE money. 

A sub lesson is that using negative gearing as a strategy on a low income makes no sense. 

So what will happen to these “losses” if the new policy comes into play.

Under the proposed policy these losses will still occur – but instead of deducting them against your current income (generating a tax refund) these losses now have to be “carried forwards” until when the property is eventually sold.

If a capital gain is made, then BEFORE capital gains tax is calculated, the losses are deducted first.

In other words, the losses only have benefit in the future.  An investor is hoping that the other reason for investing – capital growth – outweighs the loss. 

Let’s say that property rises by 8% in value this year. Your property is now worth $108,000. The loss can be justified with a very big BUT. The capital growth is a “paper gain”, the negative gearing loss comes out of your wallet each month – it’s real “in the moment”.

Investors would always prefer to be able to deduct the loss now – so investors would prefer the current policy.

One thing is clear – a negatively geared property that has no capital growth prospects is not a good investment.

And a word of caution – if investors can no longer claim the loss against income – then they will want to increase rent to cover the loss.

One of the hidden downsides in the proposed policy is its potential impact on renters.

As always if you’d like to know more or get advice tailored to your own personal circumstances, just Ask Alan – Your online mortgage broker.