Property Tax Mistake: Not Understanding Gearing
It’s very important for you to know the difference between a positive and negative cash flow property. Here’s a brief description of both to help you identify the possibilities of each.
Imagine you could buy a property and every time you went to pay the mortgage, the rent generated from your property covered your monthly interest payment to the bank and all your other costs, such as rates, levies and so on. Would that make you think differently about property? There is no need to imagine, as high-yielding properties that offer this are certainly in the market. They are either known as positive cash flow or positively geared properties.
The mild difference is geared properties need to include possible tax deductions from the property to create the cost-free, cash flow positive scenario. To simplify it further, let’s use some basic numbers.
Let’s pretend you have bought a property for $100,000 and the interest rate of the day is 6 percent. You borrowed 100 percent, being $100,000. You would be paying per annum around $6000 in interest. Positive cash flow properties have high rents. In this example we shall use $200 a week or a 10 percent rental return. Your gross rent is now $10,400 per annum. You now have $4400 a year left to pay rates and outgoings and should be left with a surplus of cash. This principle is known as “positive cash flow”.
Genuine positive cash flow properties should give the benefit before tax and not be reliant on deductions. Positively geared properties are when the rental return is higher than your loan repayments and other outgoings after consideration of depreciation and other tax deductions. Properties within the market that can’t produce a pre-tax positive cash flow result are either positively geared by tax deductions or still negatively geared. I am a big advocate of gearing your portfolio to be sustainable and self-funding.
Negatively geared properties are when the rental return is less than your loan repayments and other outgoings (placing you in an income loss position). Why would anybody do this? Because there is the underlying expectation that the accumulated losses will be more than offset by the capital growth on the property. In this circumstance the rental return is not considered as important as the capital growth potential in the decision process. The key benefit associated with negative gearing is that the loss associated with the property ownership can be offset against other income earned, reducing your assessable income, thereby reducing your tax payable.
The result is that the cost of owning the property is being funded by your tenant (in the form of rent), the Tax Office (in the form of tax savings) and your surplus cash flow. Ultimately, most investors will aim to be positively geared in the long run. Generally high-income taxpayers choose the negatively geared investment option to maximise their tax returns and benefit from the long-term capital growth potential. Investors who are closer to retirement or in a lower income bracket may choose positively geared or cash flow investments to maximise their income potential.