Tuesday, July 22, 2008

What is negative gearing?

Negative gearing is when you borrow to invest and the income you earn from your investment is less than the interest and other associated costs. This loss is claimable against your other earned income – typically your salary or wages.

How does negative gearing work?

A property is negatively geared when the costs of owning it – interest on the loan, bank charges, maintenance, repairs and capital depreciation exceed the income it produces. In simple terms, your investment must make a loss before you can claim the tax benefit. Negative gearing not works only for property, but also other investments like shares and bonds.

Claimable expenses

Property owners can claim deduction and depreciation against income on the property. There are three main classes of deductions available to investors:

  1. Revenue deductions – These include interest on the loan as well as ongoing maintenance and expenses such as agent’s fees, council fees, advertising charges, bank fees, body corporate fees, cleaning expenses, and insurance.
  2. Claims for capital items – Large capital items such as a hot water service, white goods, etc are subject to depreciation. This means the owner must claim the cost over a number of years rather than all at once.
  3. Claims for building allowances – Owners can also claim depreciation of capital works, specifically for building and landscaping. The current rate is 2.5% over 40 years. Commissioning a depreciation schedule from a qualified quantity surveyor is a good way to maximise your depreciation allowances.

Keeping it at arm’s length

In order to claim deductions your dealings with tenants and lenders must be at arm’s length. If you’re renting your property to a family member or a friend at less than the commercial value then you’re not acting at arm’s length, and you cannot claim deductions as you would in a purely commercial arrangement

Keeping records

It’s easier to get your tax right if you’re keeping good records, and this is very true of rental deductions. If you’re keeping good records, it’s much easier to understand which category your expenses fall into, and makes completing your tax return a much simpler task.

Risks associated with gearing.

There is an inherent risk associated with borrowing to fund any investment. While gearing can help you increase your gain on borrowed funds, the losses can be large in adverse circumstances.

As a general rule, only investors with the financial capacity to absorb the effect of potential falls in investment values, as well as an increased cost in interest payments, should consider negative gearing.

You can minimise the risk of gearing by:

  1. Choosing your investment property carefully. You need to try and select a property that is likely to increase in value throughout the investment period.
  2. Having sufficient income to cover the interest repayments if your tenants are late with their rental payments, or if your property remains vacant for any time. You also need to be able to fund ongoing repairs and maintenance.
  3. Taking out Mortgage Protection Insurance with your investment loan

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