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Tax Effective Gearing

It’s time to get your tax back.

Introducing tax-effective geared investing.

It’s a term that sounds complicated but it’s really quite simple and can have massive benefits for investors.

Whether you’re new to the property investment market or have been in the game for a while, many investors are intimidated by the connotations associated with ‘negative’ or ‘positive’ gearing so we prefer to consider an investment strategy that focuses on ‘tax effective geared investing’.

Although it sounds technical, it’s actually a simple process that can save you thousands of dollars, come tax time. It’s time to debunk the meaning of ‘negative gearing’ and start to think about ‘effective gearing’. To do that, we need to take a closer look at negative gearing and understand all of its elements.

What is gearing?

Put simply, gearing relates to the specified ratio of debt in an investment to the value of its equity.

Gearing arises when you have an available sum of money, let’s say $80,000, which you use as a deposit to borrow a greater sum of money, for example $320,000.

You then combine these two amounts together to purchase an investment property for $400,000 (debt + equity).

This investment is then known and referred to as ‘geared’, as the amount of money you had available ($80,000) has been ‘geared up’ by five, allowing you to purchase an investment property worth five times the amount you had available. In this sense, you have been able to borrow 80% of the total investment, which has now become your mortgage. In essence you have borrowed money to fund a larger investment. This is known as ‘gearing’.

What is negative gearing?

Negative gearing simply means your annual return on your investment property is resulting in a loss – you are out of pocket. This is usually the case when you are spending more money on the property than the income it brings in via rent. There are two parts to this equation – the costs and the income.

The Costs (what you spend) The Income (what you receive)
  • Interest costs on mortgage repayments
  • Rental Income
  • Property Management Fees
  • Tax credits
  • Lenders Mortgage Insurance (LMI) fees
 
  • Rates
 
  • Maintenance
 
  • Insurances
 
  • Travel and incidentals
 
  • Depreciation
       - Plant and Equipment
       - Building Allowances
 

Put simply, if your costs exceed your income it equates to an investment property that is operating at a loss. This opens the door to Tax Effective Geared Investing.

Depreciation and its tax benefits for investors

Depreciation is another tax effective benefit of purchasing an investment property because it allows you to effectively claim a compensation or non-cash deduction for ‘wear and tear’ on your investment property against your taxable income.

There are two types of depreciation allowance available to you as an investor and they include depreciation on plant and equipment (such as dishwashers, ovens, floor coverings and window treatments) and depreciation on the Building Allowance which refers to the building cost or the value of the property at the time of purchase.

If your investment property is brand new, you are entitled to claim full depreciation benefits against your taxable income. You can only claim depreciation for up to 40 years so that is why as a property investor you are better to buy a brand new property, rather than established so you can receive full depreciation benefits.

How can you turn a negative into a positive?

Property investment is big business to the Australian Tax Office (ATO). You’re receiving an income in the way of rent but also have costs. When these costs are greater than the rental income, the ATO allows you to deduct these losses from your alternative income (such as wages), which then become tax deductible losses.

For example, imagine you earn $75,000 in salary, but lose $12,500 on your investment property. In this case, the ATO will allow that $12,500 to be deducted from your salary, so you only pay tax on $62,500. Your taxable income has been reduced and you have the added advantage of having something to show for your money – an investment property.

This is what we like to call ‘tax effective geared investing’. It turns a negative into a positive and can provide enormous benefits for investors. That’s why the majority of investment properties in Australia are ‘tax effectively’ geared.

How can effective gearing earn you more money?

Gearing your original deposit and borrowing money from the bank to purchase an investment property will generally earn you more money than simply investing your original sum on fixed interest with the bank. This works because you have a larger sum working for you to earn you bigger returns.

For example, let’s compare the results if we take the original amount of $80,000 which was available to invest and invest it with the bank at 5% per annum, compared to if you borrowed against it to purchase a $400,000 investment property with assumed annual capital growth of 5% (growth in the value of the property).

Time frame (years) Bank deposit @ 5% interest Investment property at 5% annual growth
1 $80,000 $400,000
2 $84,000 $420,000
3 $88,200 $441,000
4 $92,610 $463,050
5 $97,240.50 $486,202.50
6 $102,102.52 $510,512.62
7 $107,207.64 $536,038.25
8 $112,568.02 $562,840.16
9 $118,196.42 $590,982.16
10 $124,106.24 $620,531.26
11 $130,311.55 $651,557.82
12 $136,827.12 $684,135.71
13 $143,668.47 $718,342.49
14 $150,851.89 $754,259.61
15 $158,394.48 $791,972.59
     
PROFIT $158,394.48 - $80,000 $791,972.59 - $400,000
= $79,394.48 =$391,972.59

You can see the geared investment makes a profit of close to $400,000 over 15 years compared to the fixed deposit which was less than $100,000. What amount would you prefer?

Of course the example above does not take into account fluctuations in the property market. There may be a downturn and the property is unlikely to achieve consistent growth at 5% every year for 15 years. So, even if you lowered the growth to an average of 2% per annum (to allow for ebbs and flows), you are still left with more than $50,000 additional profit over the life of the investment compared to the bank deposit (as shown in the table below).

Time frame (years) Bank deposit @ 5% interest Investment property at 2% annual growth
1 $80,000 $400,000
2 $84,000 $408,000
3 $88,200 $416,160
4 $92,610 $424,483.20
5 $97,240.50 $432,972.86
6 $102,102.52 $441,632.31
7 $107,207.64 $450,464.95
8 $112,568.02 $459,474.24
9 $118,196.42 $468,663.72
10 $124,106.24 $478,036.99
11 $130,311.55 $487,597.72
12 $136,827.12 $497,349.67
13 $143,668.47 $507,296.66
14 $150,851.89 $517,442.59
15 $158,394.48 $527,791.44
     
PROFIT $158,394.48 - $80,000 $527,791.44 - $400,000
= $79,394.48 =$127,791.44

But what about the interest on the mortgage?

Obviously if you are comparing the two scenarios above you are not comparing apples with apples because with a geared investment you will be charged interest on the mortgage repayments but with the bank deposit you will not.

The difference is the interest repayments on your geared investment are tax deductible so you can deduct them from your taxable income (if your property costs exceed the income). This is unlike the mortgage on a family home where you are solely responsible for all interest repayments and none of the interest payments are tax deductible.

So even though you are paying interest on the money you borrow, this interest is tax deductible and the benefits you receive from investing with ‘geared’ money ($400,000) compared to simply investing your original amount ($80,000) are significant. This is just one of the many reasons why your geared property investment is a ‘tax effective geared investment’.

Depreciation and tax effective geared investments

Another tax effective benefit of purchasing an investment property rather than leaving money in the bank is your ability as an investor to claim depreciation for your investment property against your taxable income. Depreciation is effectively a compensation or deduction for ‘wear and tear’ on your investment property over time.

There are two types of depreciation allowance available to you as an investor and they include depreciation on plant and equipment (such as dishwashers, ovens, floor coverings and window treatments) and depreciation on the Building Allowance which refers to the building cost or the value of the property at the time of purchase.

If your investment property is brand new, you are entitled to claim full depreciation benefits against your taxable income. If your property was built after 1985, you can claim depreciation for the years the property has left before the property is 40 years old. You can only claim depreciation on the Building Allowance for up to 40 years as this is how long the ATO has deemed a building will last before it needs to be replaced.

If your investment property was built prior to 1985, you can claim depreciation on the plant and equipment only. This is why as an investor, it is in your interests to buy or build a brand new property rather than buying established.

If you were to purchase a brand new investment property, you are currently permitted to claim depreciation on plant and equipment and the Building Allowance at a rate of 2.5% per annum on the ‘as new’ value of the property. To put this in perspective, on a brand new investment property valued at $400,000 this will provide you with a non-cash deduction in excess of $10,000. This is a HUGE savings.

Another major benefit of depreciation is the fact it is a ‘non-cash deduction’ because it is the only deduction that you don’t have to pay for on an ongoing basis. All other deductions including mortgage interest, insurances and fees will all hurt your hip pocket on an ongoing basis. Depreciation is simply an added bonus and a huge tax effective benefit of investing – especially if you are buying a brand new investment property.

You will need to engage the services of a qualified quantity surveyor to determine the value of your property in order to claim depreciation – real estate agents, property managers and valuers are not permitted to make this estimate for you. The cost of the surveyor’s estimate is tax deductible and well worth the expense.

There are two ways to calculate depreciation on an investment property. The ‘prime cost’ method assumes the value of the depreciating asset decreases uniformly over its effective life, while the ‘diminishing value’ method assumes the value of the depreciating asset decreases more in the early years of its effective life.

The table below shows estimated results of how much depreciation you could claim on a brand new property valued at $400,000 over the next ten years (assuming the property has a medium standard of finish):

YEARS PRIME COST DIMINISHING VALUE
Year 1 $7,000 $11,000
Year 2 $7,000 $7,000
Year 3 $7,000 $7,000
Year 4 $7,000 $6,000
Year 5 $6,000 $6,000
Year 6 $6,000 $5,000
Year 7 $6,000 $5,000
Year 8 $6,000 $5,000
Year 9 $6,000 $5,000
Year 10 $6,000 $5,000
10 YEAR TOTAL SAVINGS $64,000 $62,000

Regardless of which method you use, the above table shows how claiming depreciation on your investment property against your taxable income can save you in excess of $60,000 over a ten year timeframe.

When you combine the value of this deduction together with the profit you earned from borrowing money to buy an investment property rather than deposit your original $80,000 in the bank, purchasing an investment property clearly has the potential to be a highly tax effective investment strategy.

Why does the Australian government support geared investments?

By providing incentives and tax benefits to investors the Australian government is effectively helping the economy. Investors are more likely to purchase or build investment properties (because of the tax and financial benefits to do so) and this provides more homes for the rental market.

Approximately one third of Australians do not own their own home and choose to rent. Investment property owners fill this gap and provide homes for rent which decreases reliance on the government to provide greater levels of house and the government can rely on investors to provide this service instead.

There has been debate in recent times about the potential for negative gearing to be abolished because investors are buying a larger number of homes which is pricing first home buyers out of the market due to lack of housing supply. If negative gearing was abolished, it has been argued that less people would purchase investment properties (or would choose to sell their existing investment properties) resulting in a greater supply of houses for first home buyers.

There are no proposed changes to gearing laws at this time.

Wouldn’t positive gearing be a better option?

To have a positively geared property investment, the income from the investment property must be higher than the costs. This has its advantages because you are receiving an income from the property each week and there is less risk. If your circumstances change or if you were to lose your job you are less likely to need to sell the property under pressure, which can be fraught with danger if you are forced to sell in an unfavourable market.

However, a positively geared investment property means you are earning more income which is taxable. You are required to pay more tax and miss out on the tax advantages of a negatively geared property.

The benefits of tax effective geared investments are immediate.

There is more good news for tax effective geared investments. Although the government provides a tax credit on investment properties, there’s no need to wait until the end of financial year to enjoy the benefits.

Instead, you can complete an Income Tax Withholding Variation which, once approved, will allow your employer to reduce the amount of income tax they withhold, providing you with the cash flow to support your investment property. This will make owning an investment property from day one easier.

Why doesn’t everyone own a tax effective geared investment?

This is a good question.

Many people hold back due a lack of understanding of how tax effective geared investing works, or the fear of making a mistake. Others fear taking on more debt, or don’t know how to choose the right type of property and location. Many worry about managing an investment property whilst others are time poor and don’t know where to go to get the right investment advice.

These are all valid considerations but you need to weigh up the alternatives. It has been widely reported that the majority of Australians will be under-funded in their retirement years and will have to rely on the pension to survive. This is particularly the case for women, even more so for single women.

It is hard to find opportunities to plan for retirement or to build your financial security because generally after the mortgage, taxes and living expenses are paid each month there is very rarely anything left to squirrel away to build a nest egg. And even if there was, it won’t amount to much. How long would it take you to save an extra $300,000 or more?

Investing in property can help you achieve your monetary goals, build your assets and gain financial freedom and independence. Through tax effective geared investing, not only are you on your way to building your property portfolio, but it provides you with the opportunity to purchase real estate that you might otherwise not be able to afford.

Once you’ve made the decision to take the next step, it is important to completely understand the process.

Seeking advice from a reputable property investment company will help you work through any issues or concerns that may be holding you back from creating wealth, and reaching your full financial potential.

How to find out more.

Investor Assist has an expert team of Property Investment Specialists who are highly experienced with tax effective geared investments and can explain the advantages and considerations in thorough detail. To book an appointment, contact Investor Assist here

Investor Assist also hosts regular Property Investment Seminars which cover a wide range of topics including tax effective property investment. Details of upcoming seminars can be found on the Investor Assist website – be sure to book your spot early as they always fill up fast!