Negative gearing explained: How to turn a $13,200 loss into a $180,500 profit

Few areas of the tax system have attracted as much attention as the rules around negative gearing. A legitimate use of the rules to help mum-and-dad investors or a rort at the expense of the rest of the taxpaying population?

Whatever your view, there’s no doubt this area of tax law is politically controversial and, with a General Election just round the corner, is sure to come under scrutiny. So, what exactly is negative gearing and how does it work?

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The basics

The tax laws of this country contain provisions which in many cases enable taxpayers to offset losses which they incur in one field of economic activity either against future profits from the same activity or from current profits from other fields of activity.

To give a simple example, let’s say that you run a small farming business and also have a paid employment as a truck driver. In a particular year, you make a loss in your farming business because of poor market conditions. Usually, you would be able to offset that loss against the income you earned from your employment, generating a refund of some of the income tax paid on your employment.

The same rules apply to property investments. If you own and rent out a property, and the amount of income which you earn from the rent is less than the amount of expenditure you incur, the resulting loss can be offset against your other income or profits for the year.

Of the various items of expenditure which you incur in running a rental property, probably the most significant is the amount your pay on your mortgage.

The interest element of your mortgage repayment is deductible for tax purposes. Therefore, by gearing your property to the maximum level possible under the rules allowed by your bank, you can also maximise the size of the interest charges you can claim as a tax deduction.

In a common scenario, the amounts which you earn in rent are less than the amounts you spend on your rental property, including mortgage interest plus all the other tax deductible items such as land rates, water rates, insurance, capital works deductions and repair costs.

That means that you’ve made a loss on your rental property and the tax law allows you to offset that loss against your other income.

This is a valuable relief but it needs to be put into perspective. Yes, you’ve generated a tax loss which will allow you to recoup some tax you’ve paid or are due to pay on other income. But you have actually made a real economic loss. So, although you might get tax back at between 19 per cent and 45 per cent (depending on your marginal tax rate), you have actually lost 100 per cent of the shortfall.

Why negative gearing is 'desirable'

What really makes negative gearing so desirable is the way the tax law then treats you when you choose to dispose of the property.

Basically, when you sell a property, you are subject to capital gains tax (CGT) on the profit (which in very simple terms is the difference between what you paid for it and what you sold it for). CGT is levied at your marginal tax rate (between 19 per cent and 45 per cent, as per above). But, if you own an asset for more than 12 months, you become eligible for the 50 per cent CGT discount. This basically halves the amount which is subject to tax, and is equivalent to halving the rate of tax you pay on the full gain.

Where people make money from negative gearing is on the potentially favourable interaction between the on-going losses on the rental income and the profit which hopefully will arise on disposal of the property.

In short, you make a series of small, annual losses on your rental income (for which you receive tax relief at your marginal rate) but then at the end, you make a potentially large capital profit on the disposal (which is taxed at half rates, effectively). The large profit on disposal more than outweighs the small, cumulative losses on rental income and..hey presto!...overall, you have made a very substantial total return on your investment. This is particularly the case in the current economic environment where rapidly rising property prices are leading to bumper profits for investors selling their rental properties (often to other investors!).

Let’s look at a numerical example:

Bob buys a house in Melbourne for $500,000 in 2016.

He pays monthly mortgage payments of $1,600 and has other monthly outgoings (all tax deductible) of $400. He receives monthly rental income of $1,600.

He sells the house in 2021 for $750,000. He has other income of $250,000 per year.

Bob can offset the loss of $4,800 per annum against his other income to generate a tax refund of $2,160 dollars per year ($4,800 x 45 per cent).

On disposal, Bob makes a capital gain of $250,000. After the CGT 50 per cent discount, his taxable gain is $125,000. He therefore has a tax liability (at 45 per cent) of $56,250.

Bob’s after tax return over the five year ownership period is therefore as follows:

These numbers are provided for illustrative purposes only.

Looking at those numbers, it can be seen that there are potentially large profits to be made by negatively gearing a rental property.

But there are also caveats:

• To work, a negative gearing strategy must operate in a time of rising house prices. If prices are stagnant or falling, you can find yourself in a financial pickle.

• Negative gearing works best at the top tax rates because those rates give the biggest tax breaks. At the lower tax rates, the benefits shrink proportionately. The on-going costs of running a property at a loss over many years can stretch taxpayers on more modest incomes to breaking point. Of the 1.9 million taxpayers who declare rental income, it’s estimated that three quarters are earning less than $80,000 per year (and hence getting relief at a marginal rate of 32.5 per cent rather than the 45 per cent used in the example).

• Finally, and obviously, the strategy relies on the tax law staying as it is. Having said that, there are no firm proposals to change the law, particularly after the Labor party got burnt with its policies to reform negative gearing at the last election.

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