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Part 2b – Negative Gearing Jake while talking to a friend (Max) at a party is...

Part 2b – Negative Gearing

Jake while talking to a friend (Max) at a party is informed about a topic called “negative gearing”. Tax advantages were discussed so Jake is seeking your advice. He was also told about potential changes should there be a change in Government. In your own words, explain “negative gearing” to Jake and the potential changes that may occur. In your own words, students should discuss the potential tax benefits for someone earning $100 k per year.

300 words

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Expert Solution

DEFINITION of 'Negative Gearing'

Negative gearing is a form of financial leverage and is commonly used in the context of property investing. Negative gearing involves borrowing money to buy an income producing asset, such as a rental property, when the asset won't be able to produce enough income to cover the loan payments, cost of maintenance, interest, or depreciation in the short term. Ideally, the asset will eventually produce enough money to cover those costs. These losses can be beneficial to the owner's tax bill in certain instances. Depending on the investor's home country, the shortfallbetween income earned and interest due can be deducted from current income taxes. Countries that allow this tax deduction include Canada, Australia and New Zealand. Investing in such a way might make sense in instances where large capital gains are expected at the time of sale which make up for the intermittent losses.

Negative gearing occurs when an investor purchases an income producing asset using a loan, and the income produced by the asset cannot cover the loan payments or other expenses associated with the asset. Negative gearing most often occurs in rental properties, where the rental income received isn't enough to cover the loan payments, interest costs on borrowings, plus expenditures toward property maintenance and upkeep.

Negative gearing only becomes a profitable venture when the property is eventually sold, and a prerequisite is that property values are rising, not falling or holding steady. If property values are falling or holding steady, it is difficult to sell the asset for the gain necessary to make up for the losses while the asset was held and not producing income to cover expenses. Many investors who speculate this way will purposely seek out negative gearing for the tax deductions in the hope that they will make a profit when the property is sold for a capital gain.

Investors considering this type of arrangement need to have the financial stability to fund the shortfall out of pocket until the property is sold and the full profit can be reached. Also of utmost importance is that the interest rate is locked in from the beginning or, if the borrower's interest is calculated on a floating index, that prevailing rates remain low.

How does it work?

The basic concept of negative gearing is turning a negative into a positive.

The main aim of any investment is to make a profit, but unfortunately that doesn’t always happen. From an unexpectedly low rental market to unforeseen expenses when purchasing a property, there are several reasons why the cost of an investment can outweigh the income it generates. This is a negative outcome, but you can use it to your advantage when tax time rolls around.

The cash loss you notch up on your investment can be used to offset the income you receive, for example from your salary or wages, meaning that as a whole you will be required to pay less tax to the ATO.

In effect, you can use the taxation system to bear the brunt of the impact of your investment loss in the short term, and in the long term you will hopefully make a capital gain on your investment when the value of your property rises.

What you can claim

According to Australian tax law, you may be able to claim the interest portion of your loan repayments and also some other costs as an expense, providing the property is available to be rented.

The key benefit associated with negative gearing is that any loss may be offset against other income earned, such as your salary, reducing your taxable income and therefore your tax payable.

Some things to know

While negative gearing can have financial benefits, there's often a lot more to investment properties than reducing tax.

The income from positively geared properties, for instance, can help to improve buying power by putting money into your account and can increase your ability to meet repayments.

In general, taxpayers with a higher taxable income may choose a negatively geared investment property in order to claim any loss on the property against their other taxable income. They may also benefit from any long-term capital growth potential.

Investors closer to retirement or in a lower income bracket may choose positively geared investments to maximise their income potential.

As with all investments, strategies should be aligned to personal circumstances and risk preferences. You should consider talking to a professional financial adviser or accountant or tax specialist if you are thinking about investing.


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