Gearing is the process of borrowing funds to purchase a property
that you would not be able to purchase with your cash funds alone. Negative
gearing occurs when the expenses and loan interest exceed the rental income,
leading to a net loss which can reduce your tax payable. This guide will run through
an example to illustrate the process of negative gearing.
Property Selection
Before delving into an example of negative gearing it is worth exploring the features
that make a property suitable for investing in. Buying a property for investment should
not be an emotional process (unless you intend to live in it later) and instead should be
approached from a financial perspective.
Rental Yield
The rental yield is a measure of the property's gross and net income compared to the
value of the property. Gross yield equals annual rent divided by the value and net yield
equals the annual rent less the cash expenses all divided by the value of the property.
You can use this percentage to compare properties with different prices and rental amounts.
Properties with higher rental yields will produce greater returns.
Rental Yield
Cost of Property 1
Annual Rent
Annual Cash Expenses
Net Rental Income
Gross Yield (14,000 / 200,000)
Net Yield (12,000 / 200,000)
Cost of Property 2
Annual Rent
Annual Cash Expenses
Net Rental Income
Gross Yield (11,000 /150,000)
Net Yield (9,400 / 150,000)
200,000
14,000
2,000
12,000
7.00%
6.00%
150,000
11,000
1,600
9,400
7.33%
6.27%
Potential Rental Growth
This is an estimate of the expected rental growth over time and being an estimate is difficult to quantify.
Your real estate agent will be able to point you in the direction of good growth areas. It is vital that rental
growth exceeds inflation over the term of the investment.
Potential Rental Growth
Rent of $200 p/wk growing 5.00%
Rent of $200 p/wk growing 3.00%
Potential Capital Growth
Capital growth is an estimate of the expected change in the value of your property
from one year to the next. Good capital growth quickly increases your equity allowing
you to borrow again for further investments, and also reduces your investment risk
because your total debt is lower as a percentage of the property's value.
Potential Capital Growth
Value of $200,000 growing 5.00%
Value of $200,000 growing 3.00%
The Age of the Property
Properties constructed after 18 July 1985 provide greater tax deductions in the form
of building allowance and may also have less costs involved in repairs and maintenance.
You would need to weigh up the price difference in pre and post 1985 properties and
measure the extra benefits from the newer property.
Age of Property
Construction Costs
Extra tax deductions if constructed
after 18 July 1985
Example Details
The following example property will be used to demonstrate the process of negative gearing.
The example is deliberately simple and does not cater for complex scenarios such as the property
being used as a residential dwelling for some period of ownership.
The loan is assumed to be a Principal & Interest loan (P&I) over a period of 20 years with a 7 percent interest rate.
Assets include such items as carpet, furniture and fittings and, since the property was constructed
after 18 July 1985, we are able to claim a percentage of the construction costs as a tax deduction.
Example Details
Purchase Details
Date of Purchase
Price
Purchasing Costs
Total
Loan Details
Loan Type
Interest
Amount Borrowed
Deposit
Borrowing Expenses
Income & Expenses
Annual Rental Income
Annual Cash Expenses
Asset Details
Value of Assets at Purchase
Construction Costs
Date of Construction
Construction Details
1 July 2000
200,000
6,000
206,000
P&I 20
7.00%
180,000
26,000
500
14,000
2,000
5,000
1 July 1990
100,000
Taxable Income
The table shows a basic calculation of the property's taxable income or loss.
The rental income is reduced by normal cash expenses, by the interest portion of
your loan repayments and by the non cash expenses.
The non cash expenses include a percentage of the original asset value, a percentage
of the initial borrowing costs and a percentage of the construction costs.
The total loss in this example is $4,050 but this is not the amount of cash required to
fund the investment. In the next sections we will see the tax concessions applicable to this
loss and see how they impact on the cash flow.
Taxable Income
Annual Rental Income
Annual Cash Expenses
Loan Interest at 7.00% p.a
Asset Depreciation
$5,000 x 20% for full year
Borrowing Expenses
$500 x 20% amortisation
Building Allowance
$100,000 x 2.5% amortisation
Total Taxable 'Loss'
14,000
(2,000)
(12,450)
(1,000)
(100)
(2,500)
(4,050)
Tax Concessions
The amount of tax concessions for the property is calculated by comparing the tax payable
on your pre investment income to the tax payable on your post investment income.
Under the marginal tax system a lower income earner pays less tax on each extra dollar earned
than a high income earner. Equally, a lower income earner receives a lesser tax concession
for each dollar of investment losses.
You should see your accountant about estimating your total annual investment loss early
on in a financial year and applying for a variation to your tax so that less tax is taken
from your wages. The extra take home pay is best used for contributing to your investment.
Tax Concessions
Pre Investment Income
Tax Payable on $50,000
Taxable Loss from previous table
Post Investment Income
Tax Payable on $45,950
Total Tax Concession
( 12,130 - 10,855 )
50,000
12,130
4,050
45,950
10,855
1275
Cash Flow
In this section we can see how the taxable income relates to and differs from the actual
cash contributed to the investment. The following table shows which items are included in
your taxable income and which items are included in your cash flow.
Cash Flow - Item
Rental Income
Loan Interest
Loan Principal
Cash Expenses
Non Cash Expenses
Depreciation
Borrowing Exps
Building Allowance
Total Taxable Income
Tax Concession
Cash Flow
Taxable
14,000
(12,450)
(2,000)
(1,000)
(100)
(2,500)
(4,050)
Cash
14,000
(12,450)
(4,705)
(2,000)
1,275
(3,880)
Loan Type
Most borrowers use and are familiar with the standard Principal & Interest loan.
With this loan, the repayments meet the interest charge and also reduce the loan balance
so that it is paid out over time.
Another type of loan is the Interest Only loan whereby the repayments only meet the interest
charge and bank fees and the loan balance remains at a relatively steady balance.
One of the advantages of an Interest Only loan is that it greatly reduces the cost of investing
as you can see in the following example. The 'extra' funds can be used within your investment
to lower the balance of your loan or to invest in more property or a more expensive property.
Cash Flow - Item
Rental Income
Loan Interest
Loan Principal
Cash Expenses
Non Cash Expenses
Depreciation
Borrowing Exps
Building Allowance
Total Taxable Income
Tax Concession
Cash Flow
Taxable
14,000
(12,450)
(2,000)
(1,000)
(100)
(2,500)
(4,050)
Cash
14,000
(12,450)
*0
(2,000)
1,275
*825
Types of Growth
Capital growth is the change in value of your investment from one year to the next.
If you sell a property the increased capital value will result in greater cash returns from the sale.
If your property is not sold, the increased capital value increases your ownership, lowers your
investment risk and increases your ability to meet the Loan to Value ratio test if you are looking
to add a further property to your investment.
Rental growth is the change in your rental income from one year to the next. Growth in
your rental income reduces your tax concessions but the overall effect is to reduce the
amount of funds required for your investment thereby freeing up more funds for use in
loan reduction or for adding new properties.
Wages growth is the growth in your wages from one year to the next and hence growth in the
amount of funds that you have available to contribute to your investment for loan reduction
or for adding a new property.
Growth in the capital value, rental income and in your wages allows you to add new properties to
your investment and to grow your overall equity more than could be achieved with a single property.
Disclaimer
The information presented on this website does not constitute financial advice and is for general
purpose use only. You should always consult your financial advisor before making investment decisions.
