Is negative gearing worth the risk?
Previously, we talked about leveraging the equity in your home to potentially buy an investment property.
We gave an example of someone using the equity in their home to purchase an investment property, with a rental return of 10 percent of the property’s value per annum.
Now we investigate how using the equity in an existing property may affect you financially when your investment property is negatively or positively geared.
The differences in positive and negative gearing
Negative gearing is where you borrow money to invest and the income from the investment is less than the expenses. This is common for property investments, where rental income is less than interest and other expenses. Essentially this means you are making a loss.
In positive gearing, however, you are borrowing money to invest and the income from your investment is higher than your interest and other expenses. This means you will have extra money in your budget, but you will have to pay tax on the additional net income.
Are you better off negatively gearing a property?
Many investors focus on the tax benefits of negative gearing without considering the loss in after tax income. The following shows the difference between buying an investment property that is negatively geared and buying a property that is positively geared.
John and Mary both earn around $70,000 per year. They are thinking of buying an investment property. John is looking to buy a 2-bedroom apartment worth $750,000 in a high growth region of Sydney. Mary, meanwhile, is looking at a $400,000 4-bedroom home on the NSW north coast.
Interest on an investment loan will be 6 percent per annum, payable on an interest-only basis. Additional property expenses are estimated at $5,000 a year.
John is using the $200,000 equity in his home, so he will need to borrow the $550,000. Interest on the loan is $3,750 a month, which is tax deductible. The rental income is $650 per week.
Mary is using the $300,000 equity in her home, so she only needs to borrow $100,000. Mary’s interest payment is $500 a month, which is also tax deductible. Her rental income is $500 per week.
The following is based on the current tax rates and Medicare levy for 2015/16 financial year, obtained off the ATO website.
|John and Mary’s income before buying an investment property
|John’s negatively geared investment property
|Mary’s positively geared investment property
|Plus rental income
|– $ 6,000
|Less property expenses
|– $ 5,000
|– $ 5,000
|Tax + Medicare levy
John actually has less money in his pocket as most of his rental income is being paid to the bank in interest so he has to cover some of his investment expenses from employment income. He will be hoping a future capital gain will recoup his short-term income losses.
Negative gearing exposes you to risk
In John’s case, he had to use money out of his own income to service the loan for his investment property. This put him at risk of not being able to service his existing home loan. If the RBA had changed interest rates, it’s likely John would not have been able to cover both loans.
Negatively gearing an investment property should only be a short term solution, due to the financial risk it poses. In most cases, you would be better off buying a lower value property to ensure its positively geared to protect you from risk.
Want to find out more about unlocking and leveraging your equity?
Disclaimer: Please note that all information contained in this blog is purely general and should be regarded as advice only. We recommend that you always seek professional advice before making property decisions.
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