Negatively gearing an investment property - to buy or not to buy?

31 Oct 2012

By Phillip Gillard

Thinking about buying an investment property? Done your research on the property market, your suburb, the rental returns, future growth potential, bank ready to lend the money – you'd be done right, ready to buy – wrong!

Paying too much tax and like the sound of negative gearing – then borrowing to buy an investment property will save you tax and you'll be better off right? Wrong!

Investing in property requires a lot more than the considerations above. An understanding of ALL the costs, the stamp duty, the ongoing expenses, dealing with tenants, the potential for land tax, the agents fees, and hopefully capital gains tax.

It is challenging to calculate all these in advance but a reasonable estimate is possible.

A property is considered a growth asset, like shares, so when you buy you must have a time horizon of at least five years, preferably 10.

The myth about negative gearing is that it is a tax benefit. Negative gearing means that you have cash outflows each year. Yes, the tax office allows you to claim that outflow as a tax deduction which reduces the out of pocket cost, but it does not eliminate it.

If we assume an interest rate of 6.5% on your loan and a net rental income (after running expenses) of 3.5%, you have a 3.0% funding gap. At the top marginal rate you will receive roughly half back as a tax break but you will still have approximately 1.5% as a cost each year. And this analysis does not consider possible land tax or irregular additional costs, such as top-up contributions to a sinking fund or other forms of property maintenance like termite and pest checks.

When you take into account stamp duty, inspection costs and legal costs, on a purchase of $500,000 you will pay 4% in upfront costs. Then on sale, agents fees, marketing costs and legal fees will be in the order of 2%.

These high entry and exit costs emphasise the importance of making the right decision at the start and having the appropriate time horizon.

Let's convert these to a per annum holding cost for 5 and 10 years, the longer the better as you amortise the entry and exit costs:

  • 5-year holding period: 2.7%p.a. 
  • 10-year holding period: 2.1%p.a.

These are high holding costs compared to other forms of investment, and you have to factor in that a property is illiquid – you can't sell the front bedroom if you need $10,000!

You should be able to claim depreciation on the plant and equipment such as floor coverings, blinds, stoves, air conditioning, hot water systems, etc. And so you should, as these are going to cost you to replace in the future. This depreciation benefit should not be confused with a tax benefit. Just think, would you expect to be paid more for a property with brand new plant and equipment compared to that which is old and tired, of course you would. The mere ability to claim a depreciation allowance is because the tax office acknowledges that depreciating assets will cost you one way or another in the future.

Another depreciation allowance is the Capital Works Allowance. Unfortunately this form of depreciation is not a windfall opportunity to the property owner because you are required to reduce the cost base of your property leading to a larger potential capital gains tax liability on sale.

So if you borrow to buy a property, the only way you'll make money is if you make a big capital gain.

Property has the advantage that you do not value it every day so you are less inclined to make quick decisions. It has the advantage of being a physical asset which provides a sense of security, but its disadvantages are that you cannot divide it and sell it bit by bit, leading to any gains being taxed in one year, it's low income yield in retirement, and in bad markets, property can be very difficult to sell – just ask anyone owning a Noosa property at present.

Putting this altogether, it is critical to understand the real purpose of wanting to buy a property for investment. Is it to save tax through negative gearing, or to build wealth for retirement? It should always be the latter.

If you borrowed to buy you must have a strategy to pay down the debt before retirement. You need to also calculate whether you can afford to keep the property in retirement when it yields 3.0-3.5% after expenses; if not, when should you sell and what capital gains tax will you pay. Ultimately, you need to know, will it achieve your goal?

So look before you leap when buying property, do your research, do your math, consider your time horizon, and have an exit plan. It's like any other growth asset.

Better yet, seek comprehensive financial planning advice and understand your options and how you can achieve your goals and objectives.

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