Negative Gearing.

This podcast defines and explains the mechanism of negative gearing, an investment strategy where the expenses of owning a rental property, primarily loan interest, exceed the income it generates. This operational deficit results in a net rental loss, which the investor can claim as a deduction against their overall taxable income, such as salary or business earnings, thereby reducing their immediate tax liability. The podcast emphasises that this technique is most beneficial to higher-income earners who are willing to cover short-term cash flow gaps in anticipation of substantial future appreciation, known as capital gains. Finally, the podcast covers the additional complexities involved, including deductions for depreciation and the specific tax rules applied when the property is eventually sold.

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Transcript

Welcome back to our Podcast. Today Richard and I are tackling one of the most talked about and I think one of the most polarising subjects in property investment, negative gearing.

It's one of those topics, isn't it? It sits right at that intersection of real estate and tax law. And because of that, you know, the actual mechanics can get completely shrouded in noise.

Yeah, exactly. Most first time investors, they know the term exists, but they don't really know how to use it.

Or, and this is more important, how to measure the risk involved.

Exactly. So today our task is to try to explain how it all works.

Yes, The goal here is for you to understand exactly how negative gearing works and the critical financial risks that can, well, turn a wealth builder into a real liability if you don't manage it properly.

And we have to start with the absolute basics. What is gearing?

It's simple really. Gearing just means borrowing money to buy an asset. An asset you hope is going to generate income or, you know, grow in value.

Okay, so where that investment lands financially right at the start, that determines where it sits on the gearing spectrum.

That's it. You've got three main possibilities.

Let's look at that. What's the first one, the ideal one?

The ideal one is positive gearing. This is where your rental income is more than all of your investment expenses.

And by expenses you mean Everything. The loan interest, maintenance, everything.

Interest, fees, rates, the lot. You're generating a net profit, positive cash flow from day one, which is great.

But that profit is taxable income, right?

It is, but you're in the black immediately.

Okay, that's the ideal position. What's next?

Next is neutral gearing. Think of this as the break even zone. Your income and your expenses are more or less the same.

So you're not really making money, but you're not losing it either. You're just holding the asset while you wait for it to grow.

Precisely. You're minimizing what you have to tip in from your own pocket.

Which brings us to the subject of this podcast, negative gearing.

Yes, Negative Gearing is when the annual expenses of owning that property including the loan interest which is almost always the biggest expense by far. When those expenses exceed the rental income you collect, you are on paper running an annual net loss.

Okay, and this is the part that just sounds like terrible business advice. I Mean, why would any smart investor, especially a first timer, willingly choose to make a loss?

Because the short term loss isn't the point. It's a financial maneuver. It's a tactic designed to achieve a much bigger long term goal, which is Capital growth. The loss isn't a failure. It's the operational cost that unlocks a big tax advantage.

Okay, How does that actually work?

So the core idea is that the net loss you make on your investment property can be offset or deducted against your other taxable income.

Like your salary from your job.

Exactly. And that directly reduces your overall taxable income for the year.

Can you give us a really simple example just with some numbers?

Sure. Let's say you earn a gross income of say 150,000. And, and your property runs at a loss of 15,000 for the year. Your taxable income drops from 150 down to 135,000. You pay tax on less income, which means you get a bigger tax refund.

And that refund, the amount you get back, that's calculated at your marginal tax rate. 

Yeah, that's the key.. The tax savings you get from that 15,000 deduction are calculated at your Marginal Tax Rate. So for a high income earner, that deduction is worth a lot more in actual dollars than it is for someone on a lower income because they're in a higher tax bracket. In this example, their tax saving would be more than five and a half thousand dollars.

So, their savings are magnified.

Precisely. Every dollar of loss you deduct is essentially subsidized by the tax office at your personal marginal rate.

So, you know, while it often gets painted as a strategy just for the super wealthy, it's really a tool for anyone looking to build wealth.

Absolutely. The structure is available to all Australian taxpayers. We know from ATO data this is used right across middle income Australia. It is not some exclusive loophole. And it's a financial structure designed to help you hold an asset until it appreciates in value.

Okay, now let's get into the details. We need to understand what actually makes up that loss because not all expenses are the same, are they?

No, not at all. You can really break the deductible expenses into two buckets, cash costs and non cash costs.

Let's start with cash, the money actually leaving your account.

Well, the biggest one, hands down, is your loan interest. In the early years of a mortgage, almost all of your repayment is interest, and that is 100% deductible.

Which is Why properties with big loans often start out negatively geared almost always.

Correct, Then you add in all your other operational costs, your council rates, property management fees, landlord insurance, body corporate fees, all these cash expenses contribute to widening that gap between your income and your costs.

Okay, so far this is all about money you've actually spent. But now we get to a really big benefit for a first time investor. The non cash advantage. Talk to us about depreciation.

Depreciation. This is where it gets really powerful.

Why is that?

Because depreciation is a deduction you claim against your rental income, but you haven't actually spent any cash on it in that year.

So you're claiming a loss for something that didn't cost you money out of pocket.

That's it. The tax office recognizes that your asset you're building is wearing out over time, and they let you claim that decline in value as a loss.

And what parts of the property are we actually depreciating?

There are two main parts. First is the building structure itself. They call that capital works. That's a deduction spread over 40 years. And then there's plant and equipment. This covers all the removable assets inside things like carpets, stoves, air conditioners, hot water systems. You get a quantity surveyor to draw up a schedule and it can add thousands to your deductible loss.

This sounds almost too good to be true. Let's use an example to really see how depreciation works its magic.

Let's do it. So a client buys an investment property. The total rent for the year is $25,000.

Okay, so 25k in income what are the actual cash expenses.

In this example, interest costs comes to $22,000.

So just on a pure cash basis, she's actually $3,000 ahead. She's got positive cash flow.

She does, which is great for her budget. She's making a small profit, which would normally be taxable, but now depreciation enters the picture. She gets her depreciation schedule and it says she can claim $6,000 in these non cash deductions for wear and tear.

So to figure out her taxable position, she takes that $3,000 cash profit and she subtracts the $6,000 non cash depreciation.

Exactly, which leaves her with a net taxable loss of $3,000. Even though her bank account is $3,000 richer, the tax office sees a loss. So that $3,000 taxable loss is then offset against her salary and she gets a tax refund.

That is just an incredible position to be in. So she's Enjoying positive cash flow month to month. But the depreciation flips her profit into a paper loss for tax purposes.

Correct, it actually reduces her overall tax bill. The government is essentially helping to subsidize her ownership costs, even though the property is technically making her money.

That is the beauty of the strategy.

It is a great tool for optimizing your tax position but, only when it's balanced against the risk.

Absolutely. Let's talk about that. Because being able to claim deductions doesn't just make the risk disappear. What's the number one strain on an investor's budget?

It's the cash flow, without a doubt. Remember, if there is a cash shortfall you have to cover that cash shortfall every single month for a whole year using money from your own pocket.

But the tax benefit, that refund, you don't see that until much later.

Exactly. You usually only get that back when you file your annual tax return, maybe a year later. You have to be able to sustain that cash drain for quite a long time.

That could be a big problem for someone just starting out.

Yeah.

Is there a way to solve that lag to smooth out the cash flow?

Yes, and it's a critical strategy that every negatively geared investor should use. It's called a PAYG withholding variation.

Okay, what is that?

You apply to the ATO, the tax office, to adjust your net pay. What it means is the ATO lets your employer withhold less tax from your salary each payday. So instead of waiting for a huge lump sum refund 12 months down the track, you get your tax benefit incrementally every pay cycle.

That would make a massive difference.

Absolutely, It instantly boosts your monthly liquidity. It helps you cover that ongoing cash shortfall, and it drastically reduces the financial stress. Honestly, it's often the difference between a sustainable investment and one that just breaks you.

That is invaluable advice. But let's talk about the bigger picture. Risks. What happens when the market turns against you?

Well, interest rate vulnerability is risk number two. And it's probably the most serious macro risk you face.

Because loan interest is your biggest expense.

It is. So when rates go up, your expenses go up. And that cash shortfall you have to fund from your own salary gets wider and wider.

So if my cash shortfall suddenly doubles because rates jump, I need to be damn sure I can cover it.

Exactly. This demands two things. First, a stable high enough income to handle that stress. And second, a really robust financial buffer.

How much of a buffer?

I'd recommend having at least six months of the expected maximum cash shortfall sitting there in savings. You have to stress test your numbers and plan for that worst case scenario.

Okay, now for the ultimate question. If I'm deliberately taking a loss paying out of my own pocket every month, how do I know if the capital growth I'm hoping for is actually worth it?

This is the most important part. A tax break is nice, but it doesn't make a bad investment a good one.

So how do you measure it?

You use the most critical KPI for any negatively geared asset. The break even point.

The break even point. What is that?

The BEP is the minimum annual capital growth rate your property needs to achieve just to cover your out of pocket cash shortfall for the year.

Okay, that sounds like something you can actually track. It's not just a vague hope for growth. Is the calculation complicated?

It's very simple. You take your final annual cash shortfall. That's the actual amount you paid out of pocket after you get your tax benefit back.

Right

And you divide it by the property's value.

Let's use an example. Say a $400,000 property. And my final out of pocket shortfall for the year is $10,000.

Okay, so your BEP is 2.5%. 10,000 divided by 400,000. The property has to grow in value by at least 2.5% that year just for you to get your money back when you sell.

So at 2.5% growth, I haven't made any profit yet.

Not a cent. You've just broken even on the cash you put in.

So if I need that much just to stand still, what kind of growth rate should I really be targeting to make all this risk and effort worthwhile?

You should be aiming for growth rates significantly higher than your BEP. I mean, if the property only grows at 3%, then that tiny margin is barely rewarding you for the risk. You need to be targeting markets and properties that have a strong chance of hitting 5, 6, 7% annual growth consistently.

And if the market is flat or only growing at 1%? 

Then your negative gearing strategy is actively destroying your wealth. The BEP calculation forces you to focus on capital growth, not just the tax deduction.

That puts the pressure back on property selection, doesn't it? 

Exactly, It's not just a tax strategy, it's an asset selection strategy first and foremost.

So does the type of property you buy matter when you're trying to maximize these benefits.

It absolutely does. And there's a real trade off between maximizing the tax benefit now and maximizing the long term gain.

Okay, let's compare the two main options. A brand new property versus an established one.

Right. New properties are fantastic for maximizing the immediate tax benefit from negative gearing.

Why is that?

Because they yield much higher depreciation claims straight away. That maximizes the non cash loss we talked about, which is perfect for a high income earner who wants maximum cash relief against their salary right now.

But what's the catch? What's the downside of chasing that big immediate deduction?

The downside is usually a much lower land to asset ratio. Most of your purchase price is tied up in the building, which is a depreciating asset, not the land, which is the appreciating one.

Which brings us to established properties.

Established properties generally offer a much better land to asset ratio. And historically, it's the land that is the strongest driver of long term capital growth.

And capital growth is the whole point of this strategy.

It's the entire point.

Yeah.

Now, established properties might give you lower depreciation claims and they might have higher maintenance costs, which ironically adds to your negative gearing loss. But the long term play for appreciation is often much stronger.

Okay, so let's say an investor has done this for years. They've endured the cash flow strain. How do they finally cash out and realize the benefit? What's the payoff when they sell?

The whole strategy really comes together with the capital gains tax or CGT rules. The theory is that the capital gain you make when you sell will eventually wipe out all those accumulated cash losses and then some.

And the government actually incentivizes this long term play?

They do. If you hold an investment property for more than 12 months, you're eligible for the 50% CGT discount. And this is the final crucial step in that tax arbitrage loop we talked about at the start.

Let's just run through that loop one last time. So you offset your annual property losses against your salary income for several years.

Yep.

And then when you finally sell for a profit.

Your profit, the capital gain, is taxed at effectively half your marginal tax rate because of that 50% Capital Gains Tax discount. The whole tax structure rewards you for enduring the short term negative cash flow to get that large discounted long term profit.

It really brings the whole strategy full circle. It stops being about, you know, avoiding tax and becomes about tax efficient wealth creation.

Fundamentally, that's what it is. Negative gearing is a high risk long term strategy that is centered entirely on capital appreciation. The tax deduction is just a cash flow management tool to help you hold on during those expensive early years.

So what does this all mean for you, the first time investor? I think it means the success of this strategy hinges entirely on doing your numbers on rigorous financial modeling and selecting an investment that is fundamentally strong on its own, regardless of the tax break.

Absolutely. And here's a final thought to take away with you. The profitability of your investment doesn't depend on how big your tax refund is this year. It depends on whether the property you choose can consistently achieve capital growth rates significantly higher than your calculated break even point over the next decade. That growth is the only thing that justifies the short term financial pain.

So, if you need advice on investment loan structuring, please give us a call on 0419 635 692 and thanks again for listening to our podcast.