Gearing options

Put simply, owning a positively geared property is a good thing! It means that you are earning more money than the tax-deductible costs of holding the property, therefore you will have extra cash in your pocket each month. The longer you hold a property, the more likely it will become positively geared as the rent increases over time while the interest payable reduces or remains the same in most situations.

Negatively geared is a fancy way of saying that the property is running at a loss from a cash flow perspective. But you will recoup some of the cash flow loss via a reduced taxable income on your tax return. Often the better-quality properties, with higher capital growth, provide a lower rental return relative to the value of the property, meaning they are more likely to be negatively geared.

This is largely due to the fact that land value (as opposed to land size) is a key driver of capital growth.

Land value is strongest in locations that are highly sought after, whereas rent is driven by the amenity of the dwelling itself, rather than the land value, relatively speaking. This reinforces the initial point as to why capital growth oriented properties are often more likely to be negatively geared for longer.

If a property is providing a cash flow loss, then the most important aspect to optimising your financial return is to get the macro and micro location selection right. This will help to ensure that the return on investment from a capital growth perspective outperforms the cash flow losses until the property becomes positively geared into the future.

It is worth re-reading the above as it is one of the fundamental principles of successful residential property investment.

The Property Planner’s fast fact

Gearing 101

The easiest way to understand gearing in the context of owning an investment property is to think about your property as if it is a micro business.

Just like all businesses, income less expenses = profit/loss.

Income = Rent from the investment property.

Expenses = Interest paid on the loan, repairs and maintenance costs, body corporate fees, rates, water and any other expense that are tax deductible.

At the end of each year, use this calculation to determine your cash flow profit or loss on the property.

Remember, this is irrespective of any value change in the property. Historically, the greatest returns on residential property in Australia have been made through capital growth.

Let’s say it one more time, for posterity!

Negative gearing = When your investment property has run at a loss, then you may be able to claim that amount against your taxable income.

Positive gearing = If your investment property has run at a profit from a cash flow perspective, the positive cash flow is added to your taxable income.

Some people fall into the trap of striving for tax benefits, which often leads them towards newer poor quality properties which provide great deductions early on. Often financial ‘professionals’ team up with property spruikers and developers to sell the tax and cash flow benefits without understanding the asset quality of the property they are ‘selling’.

Vested interests can get in the way due to kickbacks to the finance ‘professionals’ who are usually financial planners, tax accountants and mortgage brokers. Tax benefits and negative gearing should always be considered as a secondary benefit and should never be a primary reason for purchasing an asset.

It is important to remember, a tax deduction is giving someone $1 to get at best, 48 cents back (if you are fortunate enough to be in the highest tax bracket).

This in itself is not a good strategy if the asset selected is poor. This is critical to understand. One of the core reasons many people get ‘sucked’ into the trap of buying from property spruikers and developers who have very slick sales systems is through showing how ‘cheap’ it is to hold an investment property through tax benefits of claiming interest and depreciation.

This is compounded by the fact that they offer rental incentives and that people pay more rent for new high density, high supply properties, but less as more new high density properties come onto the market to compete with poorly built and rapidly dating medium to high density apartments.

Most consumers do not realise that you pay capital gains tax when you sell on the depreciation claimed on the building during the period of ownership. This means that some of your deductions are effectively clawed back when you sell.

Further, you are able to claim depreciation on an asset for one reason, the asset is going backwards in value. If you reflect on why we can claim depreciation on a property building (or its fixtures and fittings), it helps to better understand why land value drives capital growth and how a new dwelling in particular, can detract from capital growth.

Your Mortgage Strategy is fundamental to optimising tax deductions, irrespective of your investment strategy. This feeds into forward planning regarding:

1.   The use of offset accounts.

2.   Enhancing your ability to hold properties into the future, especially should you hope to keep an existing home when you purchase a future home.

Remembering to optimise your deductions through effective mortgage strategy, whilst not letting deductions become your primary driver for your investment strategy will help drive your property and financial success. With improved cash flow over time as your rental income increases, you will have reduced tax deductions, and in time, the property will become positively geared. 

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