Are there potential risks to negatively gearing your investment property?

Important things to remember if you are planning to negative gear an investment

In short, yes. But they can be mitigated.

Negative gearing of property is an investment strategy that has been used widely over the past few decades. A plethora of promoters and naysayers have given their opinion on the practise since its inception, so with this post we will try to bring some balance to the discussion around the potential risks that you can be exposed to when negatively gearing your property. We will also provide some insights regarding how buyer’s agents may be able to help mitigate the potential downside, particularly in light of current property market conditions. 

As seasoned investors will know, core to any sound, long term investment strategy is to borrow within your means. One key concern with regards to negative gearing that pundits often brush over (or ignored entirely) is that this strategy not only increases the potential gain from an investment, but also potential losses. In simple terms, the more you borrow the greater your risk appetite must be.

In brief: what is negative gearing in relation to property investing?

A property is negatively geared when the costs of owning it exceed the income it produces from rent or other sources. This means that the combined total of interest paid on loans, insurance, bank charges, property management fees, maintenance, repairs and capital depreciation are in excess of total income generated.

Negative gearing is a form of financial leveraging. It can be a valuable and tax efficient investment strategy when an investor borrows funds to buy a property. The financial benefit to the investor is realised through tax deductions. All things being equal, when the cost of owning an investment property is greater than the income earned on that property, the investor is entitled to a tax deduction for this amount. The primary benefit of negative gearing is a reduction in the investor’s tax liability.

It is important to keep in mind that a negatively geared investment generally pays off over a long period – it will only put you in the money should it’s value appreciate enough to over time. The total appreciation in value must ultimately be greater than the shortfall between rental income and property expenses paid by the investor in the interim. Investors must also be mindful that any shortfall in expenses must be met until the asset is sold or the property becomes positively geared (i.e. rental income exceeds property expenses), which can be challenging if faced with liquidity problems.

Example: snapshot of a negatively geared property

In this example, we use some rough figures to demonstrate the financial impact of negative gearing

Karen buys an investment property costing $380,000. She has an annual taxable income of $60,000.

FY2010 

FY2011

Rental income               19,760             20,353
———————–
Expenses
   Agent commission (@ 8.25%)                 1,630                1,679
   Bank interest (380,000 @ 6.25%)               23,750             23,750
   Insurance                     700                   700
   Rates                 2,500                2,500
   Repairs and maintenance                        0                       0

   Total expenses   

              28,580             28,629
 ———————–
Net cashflow –     8,820 –     8,276
———————–
Less tax depreciation
   Capital works                 4,042                4,042
   Depreciation                 7,475                6,196
   Total taxable income –  20,337 –  18,514
———————–
Pre-investment
   Taxable income               60,000             60,000
   Tax on taxable income               11,850             11,550
   Medicare levy                     900                   900

   Total tax   

              12,750             12,450
———————–
Post-investment
   Reduced taxable income               39,663             41,486
   Tax on taxable income                 5,749                5,996
   Medicare levy                     595                   622

   Total tax   

                6,344                6,618
———————–
Tax saving with investment                 6,406                5,832
———————–
Yearly cost to own investment property                 2,414                2,444

 

Consider the following scenario: It is five years after property purchase and Karen’s circumstances have now changed. On top of an increase in interest rates on her investment loan, she is no longer employed in a job at her former salary level. She is unable to meet the cash shortfall on her property and needs to sell. The annual costs of owning the property have remained fairly constant over this period.

For the purposes of showing the effects of negative gearing her property, we will compare the financial outcome of two possible sale prices. In the first, Karen is able to sell close to her asking price of $465,000. In the other, she is forced by circumstance to accept an offer of $410,000.

Scenario 1

Scenario 2

Sale price             465,000           410,000
   Agent commission (@ 4%) –     18,600 –     16,400
   Legal and other fees –    2,000 –     2,000
   Total sale proceeds             444,400           391,600
———————–
Property cost             380,000           380,000
   Gross capital gain               64,400             11,600
   50% CGT exemption (held 5 years+) –     32,200 –     5,800
   Taxable amount               32,200                5,800
   Income tax (@ 37%) –     11,914 –     2,146
   After tax profit               20,286                3,654
   Total gain before tax               32,200                5,800
   Total gain after tax               52,486             11,600
———————–
Five years property costs (@ $2,400pa) –     12,000 –     12,000
Net Gain               40,486 –     400

 

As you can see, with the property value appreciating 22% in scenario one, Karen clearly comes out on top. In scenario two, where the asset only increases 8% in value, she comes very close to breaking even but would likely have been financially better off if the money she spent funding the property had been invested elsewhere.

There is no debate over whether negative gearing is a long term investment strategy; this is evident. What the above example demonstrates is that such a strategy can only be successful if the appreciation in an investment property’s value is sufficient to outweigh costs.

Navigating for success: how to manage the associated risks of negative gearing

1. For negative gearing to work to your financial benefit, the property value appreciation must outpace expenditure over the same period. This typically means making an investment with at least a medium to long term view. If the property is sold at (or even slightly above) the purchase price, cash shortfalls incurred in the interim will not be recouped.

REIA research indicates that over the past 20 years residential house prices have increased at an average of over 5% per annum. Having said this, it was also estimated that the 2008 US sub-prime lending crisis left 30% of mortgagees with a loan balance higher than their property value – circumstances in any market can change rapidly and without warning.

2. It is essential that investors have the ability to comfortably meet shortfall payments, particularly given that these outflows are generally higher than initial estimates (sometimes as a result the investor’s tax position). Don’t over-extend yourself and ensure that you have contingencies in place that allow for the added cost of possible interest rate increases, decreases in rental value, rental vacancy periods and unexpected maintenance costs.

3. Purchasing an investment property purely to achieve a positive tax outcome is not a great investment strategy and should be avoided.

4. Unforeseen changes in salary income also pose a risk to those employing a negative gearing strategy for their investment property. With the real possibility of cost blow outs, negative gearing is well suited those in higher wage brackets who also sit in a higher tax bracket and thus have more to gain on the tax reduction front.

A negatively geared property can still be an effective investment strategy for those with moderate income, but be sure to account for lower than expected changes in salary or bonuses as well as the potential impact of serious illness or injury. Many risks that may lead to a reduction in income can be mitigated by appropriately structured insurance. All property buyers should make it a top priority seek insurance advice from a qualified financial planner.

The final word

It is important to note that whilst there are tangible risks associated with negative gearing, this is still a legitimate method for wealth creation. In particular, investors may be able to access the type of potential high growth properties that buyer’s agents are able to source where this would not be possible if depending solely on their own funds or a higher up front cash investment.

Tax benefits should form part of the decision making process when deciding whether to purchase an investment property and expert advice should be sought from your tax advisor. Tax benefits should not be the sole driver in a property acquisition, with the quality of the investment being the foremost factor in any strategy. This is where buyer’s agents can add real value when making a property investment. Effective buyer’s agents will help investors to identify the suburbs and property types that have the highest potential for capital growth. Your agent should also contribute in depth knowledge regarding rental returns and vacancy rates.

Positive gearing is something that will be covered in greater detail on this blog in the future. In the meantime, it is worth noting the concerning trend in online and other literature stating that it is not possible to purchase an investment property that provides positive cash flow and value appreciation. This is a fallacy, however I acknowledge they are difficult to find with such properties being few and far between and quickly snapped up when they do hit the market.

About the Author: David is an avid web, finance and property geek who decided to combine these interests and found BAG in his spare time. If you have thoughts, issues or questions you can find him at LinkedIn, Google+ or alternatively drop him an email david at buyersagentguide.com.au

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