Have you been left reeling by your tax return? If so, you’re certainly not alone. It can be quite a shock to see just how much of your hard-earned income has gone to the taxman. This is why investing in property with their tax refund is a popular choice among Aussies.
Through a process called negative gearing you can reduce the amount of income tax you have to pay each year while building up a nice pool of equity in a home.
That’s the theory, anyway.
If you’ve heard the term ‘negative gearing’ but never really understood what it meant or how it could work for you, let us explain.
Understanding the risks of investing in property
As with any investment strategy, of course there is an element of risk.
Whenever you gear an investment you’re getting yourself into debt. Negative gearing means you’re deliberately setting it up to make an annual loss – the rental income is lower than the total cost of your loan repayments and other expenses.
But why on earth would you want to deliberately make a loss from an investment?
Well, there are two things that need to happen to make this work in your favour.
Firstly, you claim that loss as a deduction on your annual income, so your annual tax bill reduces. If you’re a big earner in a higher-rate tax bracket, the savings are even greater. You might save yourself thousands of dollars a year in income tax.
The second element, where you stand to make the biggest gains (or losses), is property value. Historically, Australian real estate has increased in value faster than the rate of inflation.
Combine these two factors and, if you get it right, you stand to save money every year on your tax bill and then make a nice lump sum when you eventually sell the property on.
Crunching the numbers
Let’s run through a quick example.
Say Darren buys a property for $400,000 as an investment. He repays $25,000 the first year in interest on the loan but only receives $15,000 in rental income. This means a loss of $10,000 before other expenses are taken into account. Darren can deduct this ten grand from his taxable income for the year.
After a year, Darren decides to sell the property. The value has risen to $500,000 so he makes a profit of $100,000. This amount is subject to capital gains tax (CGT) at his normal marginal tax rate. Since Darren owned the property for over a year, he gets a 50% discount on the amount of CGT he has to pay.
Of course, this is just an ideal scenario. In real life it’s not always that easy to make yourself 100k. If property values drop you could end up making a loss on the sale but you’ll still have to repay the full amount that you borrowed.
If you’re interested in finding out more about how negative gearing could work for you, just drop us a line or talk to us today: