In our last article before the end of the year we wanted to touch on a topic which in our experience is not always fully understood. Let us explain what negative gearing is and how it works in practice.

What is it and How Could it be of Benefit to You.

Negative gearing is the mechanism whereby currently the ATO gives you a tax concession on the costs that you incur that are related to investment assets, including investment properties. In essence, they allow you to deduct most of the expenses related to that investment from the income that the investment generates, resulting in a net profit or loss on that specific investment – this net gain or loss is then added to or subtracted from the remainder of your taxable income. This mechanism can have clear tax benefits if your overall loan portfolio is structured and administered in the correct way.

What am I Allowed to Deduct?

It’s crucial to understand which costs associated with investment properties are allowable deductions. Of course the primary cost tends to be the interest that you pay on the related loan, together with body corporate fees, cleaning, council rates, insurance, land tax, property agent’s fees, and water charges and in some instances depending on your specific property, potentially your share of the depreciation expense of the building. Your accountant or the ATO are best placed to advise you on which deductions are allowable and which are not. It’s also important to understand that when it comes to the loan expenses related to this property, the test that the ATO uses, is a test based on “purpose” – i.e. for what purpose the debt relates to. People often make the mistake of believing that they can increase their investment property loan, extract surplus equity to purchase their owner occupied home and still have this regarded as investment debt – based on the purpose test, this is not investment related debt, but rather mixed purpose debt and hence not normally all tax deductible debt.

A key point to remember though is that whilst negative gearing may leave you with a tax deduction, that scenario may well leave you in the short term with a negative cash flow situation with regards to that specific property – if your costs are exceeding your income, you will need to ensure you are in a position to be able to contribute the short fall on a monthly/yearly basis.

Good Debt Vs Bad Debt

Negative gearing is also often referenced in the expression “good debt vs bad debt”. Essentially the phrase refers to tax deductible debt vs non-tax deductible debt. As I’m sure you would be aware – costs related to your owner occupied property are not tax deductible, therefore the sensible strategy if you are in a positon whereby you own your own home and an investment property, would be to pay down your owner occupied/non-deductible debt as quickly as possible and keep your deductible debt balance as high as possible, maximising your tax position, whilst managing the combined cash flow requirements of the two loans.

In conclusion, negative gearing is a feature of the current tax system that could potentially provide you with tax benefits depending on your specific situation. If you are considering a strategy which involves taking advantage of negative gearing benefits we urge you to consult your accountant to ensure you are entitled to the benefits you believe you may be.

By Gareth Bird, Logix Finance.