Property investment is all about understanding the best strategies for you to achieve your financial goals and then researching the market for suitable properties to implement your strategy.
But some investors get into trouble because they decide to go against their own due diligence or ignore their budget entirely.
While the development of a sound strategy is essential at the start of your investment journey – as well as having the discipline to stick to it – there are also a number of other mistakes that investors make that should be avoided.
In this second blog, I’m going to discuss negative gearing, and specifically when investors think that it’s a bonafide strategy, when in fact it is not.
The truth about negative gearing
Negative gearing means that the interest you are paying on the loan and all other associated costs with the property is more than the income/rent you earn and as a result you are making a loss.
What makes negative gearing particularly useful when it comes to personal tax is that any net loss from investment properties can be offset against other income that would otherwise be included in your assessable income.
What that means is that your taxable income bracket, and ultimately the amount of tax that you need to pay, is potentially reduced.
Meanwhile, if the investment property goes up in value, but you don’t sell it, no capital gains tax will be payable.
It’s important to understand that negative gearing is available for other investments as well, such as shares or businesses.
The relevant tax legislation allow this if the investor intends to recoup their costs and make a profit.
Therefore, the tax is eventually paid.
And on the other side of the tax equation, property investors have to pay Capital Gain Tax when they dispose of the asset.
Unfortunately, negative gearing is also a political football, which is often mistakenly blamed for increasing house prices.
The problem is that many people with only a hazy idea of what it actually is, blame negative gearing for virtually everything from locking first home buyers out of the market, to causing high property price rises, to ugly greedy investors rorting the tax system and driving the National Budget into deficit.
The truth of the matter is that negative gearing is a funding model that is usually only used for a short period of time.
In fact, research from the Property Investment Professionals of Australia last year, found that 65 per cent of investors expected their properties to be positively geared within five years.
A funding model
Some investors mistakenly believe that negative gearing is an investment strategy that they can profit from, but it is actually a funding model.
If you paid a bigger deposit and had a lower mortgage, the same property with the same rental and the same outgoings might be positively geared, rather than negatively geared.
So, you don’t necessarily buy a negatively geared property, but as most high growth properties have relatively low yields, it’s common for most investors to be negatively geared, at least for the first few years they own a property.
So why would anyone buy a negatively geared property?
Generally it’s because property investors hope that their income losses will be more than offset by their capital gains (the growth in the value of their property) that they can access when they refinance or eventually sell their property.
Alternatively, a negatively geared property may become neutrally or positively geared as the rental increases, but in the main, negative gearing really only makes sense from an investor’s viewpoint if property increases in value.
And in Australia this capital gain is not taxed unless you sell your property, and then it is concessionally taxed; again evoking the argument that it favours wealthy landlords.
Of course negative gearing is more favourable for taxpayers who earn high incomes.
As I mentioned last week, it is through capital growth of your property investments where true wealth can be created and where the substantial tax revenues will be collected.
Some high income earners also mistakenly believe that they should invest in property so they can reduce their tax via negative gearing deductions.
Again, because of the nature of our property market, negative gearing may be in play during the first few years of ownership – and high income earners can afford to cover the shortfall at least – but sooner rather than later rents will increase to cover more of the repayments.
So, before you know it, that investment property is now in neutral or positive gearing territory courtesy of rising rents and the fact that the original mortgage stayed the same.
Moving out of the realm of negative gearing can also happen when interest rates fall, which has occurred since the GFC, of course.
A better strategy
A much better strategy for property investors to employ is to understand what their end game is as well as their risk profile.
From that point, they can then develop an investment strategy that reflects their financial goals, their budget, as well as their personal cash flow which can be used to fund any shortfalls until their portfolio matures over the long-term.
In the meantime, the ability to claim negative gearing benefits should be viewed for what it is: a legitimate taxation deduction in the same league as claiming for a home office or work-related car expenses or indeed the initial losses when setting up a new business.
Thinking that negative gearing is anything more than that is therefore a mistake.
Please keep an eye out for the next blog in this series next week where I’ll discuss the regular mistake of some investors believing that property never goes down in value.