Gearing simply means borrowing money to buy an asset. In the case of property, you have taken out a loan to purchase a property. Negative gearing means that the interest you are paying on the loan is more than the income. As a result, you are making a loss. Neutral gearing means that the interest you are paying on the loan is equal to the income. Positive gearing means that the interest you are paying on the loan is less than the income. As a result, you are making a profit.
Negative Gearing an Investment Property
An investor borrows money to acquire an income-producing investment property. The gross income generated by the investment, at least in the short term, is less than the cost of owning and managing the investment, including depreciation and interest charged on the loan (but excluding capital repayments).
Tax Treatment of Negative Gearing
- Interest on an investment loan for an income producing purpose is fully deductible if the income falls short of the interest payable. The shortfall can be deducted for tax purposes from income from other sources, such as the wage or salary income of the investor.
- Ongoing maintenance and small expenses are similarly fully deductible.
- Property fixtures and fittings are treated as plant, and a deduction for depreciation is allowed based on effective life.
- Capital works (buildings or major additions, constructed after 1997 or certain other dates) attract a 2.5% per annum capital works deduction (or 4% in certain circumstances). The investor’s cost base for capital gains tax purposes is reduced by the amount claimed.
- On sale capital gains tax is payable on the proceeds minus cost base.
- The net capital gain is taxed as income, but if the asset was held for one year or more, the gain is first discounted by 50% for an individual, or a third for a superannuation fund.
- Losses are deductible in the financial year they are incurred and provide nearly immediate benefit.
- Capital gains are taxed in the financial year when a transfer of ownership occurs which may be many years after the initial deductions.
- Transfer of ownership may be deliberately timed to occur in a year in which the investor is subject to a lower marginal tax rate, reducing the applicable capital gains tax rate compared to the tax rate saved by the initial deductions. However, it is possible that the tax rate applied to the capital gain may be higher than the rate of tax saving for investors who have a low marginal tax rate while they make deductions but a high marginal rate in the year the capital gain is realised.
- In contrast, the tax treatment of real estate by owner occupiers differs from investment properties.
- Mortgage interest and upkeep expenses on a private property are not deductible
- A capital gain made on the disposal of a primary residence is tax-free (Special rules apply on a change from private use to renting or vice versa and for what is considered a main residence).
A negative gearing strategy makes a profit under any of the following circumstances:
- If the asset rises in value so that the capital gain is more than the sum of the ongoing losses over the life of the investment
- If the income stream rises to become greater than the cost of interest (the investment becomes positively geared)
- If the interest cost falls because of lower interest rates or paying down the principal of the loan (again, making the investment positively geared)
- The investor must be able to fund any shortfall until the asset is sold or until the investment becomes positively geared.
- The tax treatment of planned ongoing losses and possible future capital gains affects the investor’s final return and leads to a situation in countries that tax capital gains at a lower rate than income. In those countries, it is possible for an investor to make a loss overall before taxation but a small gain after taxpayer subsidies.
International Tax treatment
Australia, Japan and New Zealand allow unrestricted use of negative gearing losses to offset income from other sources. Several other OECD countries, including the US, Germany, Sweden, and France, allow loss offsetting with some restrictions. In Canada, losses cannot be offset against wages or salaries. Applying tax deductions from negatively geared investment housing to other income is not permitted in the UK or the Netherlands. Other countries which allow “rental loss offset against other income” restrict the practice to lower/middle income taxpayers who are active in managing their rental investment, as occurs in the United States; limit the practice by ensuring the investment generated a positive return over its life as occurs in Canada; possess a more effective method to reduce tax, by allowing any interest costs against the family home to be fully tax deductible, as occurs in the United States; have a lower benefit due to a lower top rate of tax, or a higher threshold for a specific tax rate, as is the case in most other countries which allow this practice.
Why is negative gearing topical now?
- Negative gearing is a hot topic issue in the lead up to the 2016 Federal Election.
- Negative gearing by property investors reduced personal income tax revenue in Australia by $600 million in the 2001/02 tax year, $3.9 billion in 2004/05 and $13.2 billion in 2010/11
- Some believe negative gearing provides a greater benefit to wealthier Australians.
- Others claim that based on their proportion of income, negative gearing helps low-income people most.
For further information and assistance, contact your Callaghans advisor.