Continued from Who really understands Negative Gearing? – Part 1
THE HIDDEN DANGERS
On the other side of the coin, pro negative gearing activists claim that property prices will escalate if negative gearing is banned, just as they did when Paul Keating tinkered with the formula in the 80’s. But this can be linked to the unnecessary bureaucratic red tape and interfering council policies. Government policies also contribute to the potential problems, with excess immigration linked to the housing supply problem and being the cause of rent and housing price increases.
But the negative gearing activists retreat into hibernation when the property market winter arrives. As the economic cycles flow, so does the positive performance of negative gearing. A number of property cycle factors make negative gearing an uninviting prospect.
When rental yields are at low levels, it is certainly a bad time to purchase a property for negative gearing. The gap at this point between rental income received and loan interest paid is significantly higher than normal periods, often being at an unviable level.Another danger is when the rents are dropping nationwide, as a fall in your rental income would equate to a widening of the income differential and increased out of pocket expenses.
The income differential can also be widened when interest rates rise. Repayments increase while rental yields remain the same. This situation is all too common and has been responsible for much grief in recent years. In both of these situations, many investors are no longer able to cover the shortfall and end up having to surrender their house, incurring a large loss in the end.
If investors are fortunate enough to ride out both of these occurrences, they face another problem when property values stand still or decline. Even a small yearly rise could mean an overall loss, with many negatively geared properties requiring a 2-3% value increase just to break even.
Other issues include tenant’s not paying rent, unexpected property maintenance and the property remaining vacant for an extended period of time. Basically, if you don’t have the income to ride out a rise in interest rates, falls in rents or property values, or unplanned expenses and rental issues, then you should steer clear of negative gearing.
ALTERNATIVES
I can never understand investors who rush like a bad bull to grab negatively geared property. They are often motivated by the desire to pay less tax, which is a ridiculous motivation to say the least. Whichever way you look at it, a loss is a loss; so they are effectively paying money to receive a tax deduction.
A more viable alternative exists and it remains located in the property market – positively geared property. The main influence behind an investment decision should be to make money. Positively geared property does this, since it occurs when rental yields and benefits exceed property expenses.
Whilst it is true that the majority of the properties on the market would only qualify for negative gearing, this does not mean that positively geared properties do not exist. There are many positively geared properties available across Australia and investors need to exercise patience instead of jumping on the first property scheme they see advertised.
There are plenty of other tax reduction strategies available, in addition to the numerous investment options. The problem is that many people prefer a tax deduction over making a profit, which is not a sensible financial decision. If their motivation for investment is to make a profit, then the other alternatives to negative gearing become more attractive.
POSITIVE MATHS
Once again using an example – lets says that a cheaper property was purchased for $270,000, once again with a 10% deposit. Rates are lower and the house is in excellent condition, requiring lower maintenance costs. As mentioned previously, depreciation isn’t a physical cost and can be added back, so we will assume the yearly expenses to be $2,000 with $5,000 depreciation.
Yearly interest payments on a 6% loan are $14,580. Adding the expenses, we have a total of $21,580 for the year. Securing rental payments of $330 per week would bring in $17,219 per year, which is a loss of $4,361. At the top tax bracket this equates to a tax deduction of $2,028.
Remembering that the $5,000 depreciation is not a tangible deduction, this is not an out of pocket expense. Balanced against the loss, the depreciation add-back leaves $639 of positive cash flow for the year. Adding the tax deduction already received, the property investor in this example has an extra $2,667 in their pocket at the end of the year and can still receive the benefits of capital appreciation.
It may also be possible to purchase a property where the rental yields exceed the interest and expense payments on the property. This is truly a positively geared investment in every sense, and generally occurs when the investor is able to purchase a property at well below market price or secures a very low interest rate on the funds.
THE END RESULT
If you do decide to jump on the negative gearing bandwagon, be aware that you are guaranteed to lose money. In fact, that’s the whole point behind negative gearing. Just make sure that you have enough cash to cover the expenses and don’t have to work extra hours or rollback life’s pleasures just to survive.
The only way you will ever get any benefit out of negative gearing is if you are fortunate enough to see your property rise in value much more than the expenses set you back. Unfortunately, the property value is not guaranteed, but the expenses are – meaning that there is a chance you will end up a significant loser at the end.
Negative gearing is definitely not a strategy which can be wielded in all property cycles. It does very well in the fast rising markets, but not so well at other times. The decision on whether to employ the strategy now all depends on whether the property market has bottomed out, which most indicators seem to suggest otherwise.
Basically, if you don’t have the income to ride out a rise in interest rates or falls in rents or property values, then you should steer clear of negative gearing. There is no point risking your financial wellbeing by gambling on the property market. At the end of the day – it’s an asset that’s purposely designed to lose money.