Negative gearing strategy straight from the textbook

negative_gearing_strategy.jpgUtilise this tax efficient plan to reap the benefits

Negative gearing has always been hot topic in the property market, giving people an incentive to borrow money to buy property with a vision to be more financially independent later in life.

But this strategy isn't pinned down to property, it can be used for any income generating assets, whether they are shares, rental properties or financial instruments, ultimately reducing the tax you have to pay.

Negative gearing is the term given when the interest paid on funds that have been borrowed to buy an income generating investment, for example shares that generate dividends, exceeds the income generated from the asset, thereby producing a tax loss.

How it works

These losses incurred on the investments can be offset against other assessable income, therefore reducing the amount of tax payable and the amount that you need to pay. Another way to look at it is that the losses are tax deductible. In the short term, the cash loss you make from the negatively geared asset is cushioned by the tax system.

Taxpayers Australia says that if the borrowed funds were used to buying the income generating asset, there is no limit on the interest deductions allowed if the investment is a passive investment. A passive investment is one with the intention of long-term appreciation and hence, a limited portfolio turnover.

But what about making a profit?

A negative gearing strategy can only make a profit if the investment rises in value by enough to cover the gap between the income of the asset and interest that is payable on the borrowed funds.

Until the asset is sold on the market, the premise is that the investor must be able to fund the gap.

Deductibility of interest

According to the Taxpayers Australia 2012 & 2013 Tax Summary, for interest to be fully deductible, the property or other investment to which the borrow funds relate, must be used for an income producing purpose.

Some of the principles relevant in determining the deductibility of interest are contained in TR/ 95/25.

  • The interest must have a sufficient connection with the income earning operations or activities if the expenses are to be deductible under s8-1 
  • The character of the interest will generally be determined by the use of the borrowed funds
  • Interest on borrowings will not continue to be deductible if the borrowings cease to be employed for some assessable income earning activity (but see 13.130), and
  • Interest on a new loan will be deductible if the new loan is used to repay an existing loan, which at the time of the second loan, was used to derive assessable income

The loss from a rental property must be shared according to the legal interest of the owners (except in situations where there is sufficient evidence to establish that the equitable interest is different to the legal interest). The legal owner of the property is recorded on the deed on the title.

[Extracted from the Taxpayers Australia  2012 & 2013 Tax Summary]

Risks

As with any smart investment, there will always be a balance of bold opportunities to match the pervasive risks.

Income risks: risks to cover negative cash flow - you must be prepared for any unforeseen circumstances that will reduce your income. Get income protection insurance.

Risk of capital loss: If the capital value of the investment reduces and the investment is then sold, the proceeds from the sale may not cover the initial loan. There is a risk that the remaining loan balance will need to be paid from other assets.

Interest rate instability: if the loan was not set up using a fixed rate, there is always a risk that the interest rate will rise, increasing the negative cash flow that needs to be covered. Solution: get a fixed rate loan.

According to Australian Property Investor, negative gearing should be used as a tool to gain a foothold into the property market rather than relying on it as a long term strategy.

Before you jump into this kind of tax efficient scheme, make sure you seek professional advice to see whether its right for you or it could cost you.

 

 

 
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