21 Nov 2018
Debt Management
Gearing: Benefits & Disadvantages
By James Vaughan-Pow | Senior Accountant at DW Mathers & Co.

One of the basic principles of Australian Tax is that costs incurred in the course of earning income are generally tax deductible.

When it comes to borrowing for an investment, this principle also applies.

Many Australians borrow to invest, particularly in property, which is a concept known as “gearing”. Ideally, people invest with the intention of making a profit, either year on year through an income stream, or upon sale of the investment.

However, if the costs of borrowing exceed the income arising from the investment, the investment is “negatively geared”.

This is important, as under current legislation this loss can be offset against other income such as salary and wages, therefore providing tax savings. Negative gearing has both benefits and pitfalls, and it is important to evaluate these before committing to an investment.

What are the advantages?

  • Tax Savings – Losses that arise from a negatively geared investment can be offset against other income. This has the effect of reducing your tax obligation, as your net taxable income has been reduced.
  • Potential cash benefits – If some of your expenses associated with the investment are accounting in nature and not being physically paid for (such as depreciation), you can end up being in an overall better cash position over the year after taking into account your reduced tax obligation.

What are the disadvantages?

  • Investments may not provide the returns you expect– An investment should only be chosen if you expect to realise a gain from it, and that gain exceeds the short-term losses you expect to occur.
  • Budgeting – A negatively geared investment is one running at a loss, and must rely on the taxpayer having additional sources of income. This can cause cash-flow issues, as you are generally reliant on the end of year tax process to reduce the effect of your losses.
  • Higher financial risk – if additional sources of income are reduced or lost, such as loss of employment, the risk becomes a lot higher. Depending on circumstances, it may be prudent for the taxpayer to look into financial products such as income protection insurance, which is also tax deductible when paid personally.

 

How does this apply in real life?

A quick case study to explain how negative gearing can affect your tax position.

Assume that you earn $75,000 before tax in the 2019 financial year from regular employment.

You also have a rental property that brings in $20,000 of rental income, but has associated expenses (repairs, insurance etc) of $7,000, depreciation of $5,000, and associated interest from the mortgage of a further $15,000.

Excluding the ramifications of the rental property, your initial $75,000 would have resulted in $16,892 of tax (including Medicare levy).

The net rental income is -$7,000. Under the current legislation, we can reduce our $75,000 to $68,000 which results in a tax bill of $14,477 (including Medicare levy).

The overall result from all this is instead of an investment loss of $7,000, you have a loss of $4,585- a saving of $2,415. Further, as $5,000 of your expenses were from depreciation and not cash paid out through expenses, you are ahead in real cash by $415*

 

Potential changes

The Labor government has signalled its intention to change these rules by abolishing this basic principle for all investors, excluding those who invest in new Australian property. This means that if your expenses exceed the income as in the above situation, there’s no taxable benefit to claim. Importantly, this policy has been examined by the Tax Institute of Australia and they announced that not only would this policy cover investments in property such as houses, but also other investments such as shares that also produce income.

Whilst this policy might sound fair initially, it appears to have far wider ramifications than intended.

Is a geared investment right for you?

Assessing an investment for both the tax and financial benefits is an important step, and not one that should be ignored. If you are thinking about investing through gearing, call us to book a no obligation meeting to discuss this further.

 

*Net Cash movement after tax = $20,000 (income) – $7,000 (general expenses) – $15,000 (interest) + $2,415 (Tax refund) = $415