04.The traps and our advice
While some property investment companies (which may also be selling property) advocate the tax benefits of negative gearing, there are plenty of traps to be aware of.
Property values may not rise, meaning you can’t recoup your losses. There’s no guarantee that the property growth of recent times will continue.
Can you afford it? You have to fund property expenses and repayments from other income.
Taxes or laws may change. For example, the May 2006 Federal Budget changed the top income tax bracket from $95,000 to $150,000, meaning that fewer property investors will be able to claim tax deductions at the top marginal rate. This, as well as a reduction in the top rate from 47% to 45% (the second tier reduces from 42% to 40%), further reduces the tax benefits of negative gearing.
On the plus side, income tax cuts leave property investors (and others) with more after-tax income and a reduction in their Capital Gains Tax rate if they sell.
For most people, negative gearing is a risky strategy, not to be entered into lightly. It’s only sustainable if you have enough income from other sources to cover your loan repayments and other expenses.
- Make your decision based on the quality of the investment, not the tax breaks. Make sure the property you’re considering is fairly priced, and consider getting independent licensed financial advice about suggested investment and tax strategies before proceeding.
Don’t rely on a property company’s forecasts — if it’s also trying to sell you property, its advice, which isn’t regulated in the same way, or subject to the same rules as advice about other investments, can’t be considered independent.
- Negative gearing is most advantageous to those paying income tax at the top rate and with a steady income (the Treasurer says that from 1 July 2006 less than 2% of taxpayers will pay tax at the top rate). The long-term objective is to convert income into a capital gain that’s taxed at a lower rate.
Risks can increase considerably if property prices don’t rise enough to cover your losses.
- While negative gearing can reduce your income tax while you own the investment property, you’ll have to pay capital gains tax if you make a profit when you sell.
- You should consider income protection insurance, to cover you against an unforeseen loss of earnings (premiums are generally tax deductible, depending on your circumstances). If you can’t maintain mortgage repayments you could lose the property.
- Investing in property has drawbacks compared to other investments like shares and managed funds — for example, it requires a bigger outlay, it’s harder to sell your investment and investing in a single property concentrates your risk.
Positive gearing (where you make net gains and pay extra tax) may be the best strategy for most direct property investors. The risks are lower and any capital gain benefits are the same.