If you are lucky enough to live in a country which allows negative gearing, then this can be a great incentive to buy property as an investment.
However, you should never look to buy a property simply because it will reduce your tax bill. Negative gearing only helps to lessen the cash loss that you make.
If you buy a property and it costs you $100 a week to hold, that is a loss, also known as negative cash flow.
You would only accept this loss if the future capital gains would cover the loss and then some!
Then with the benefit of deducting your loss, you may only be paying $60-$70/week to hold instead of $100…but it’s still a loss!
You should always try to get neutral or positive cash flow from your property, but don’t do it at the sacrifice of buying in an area that has short and long term capital gain potential.
Consider the following scenarios:
You buy a property in a good area which has the potential to achieve 10% pa capital growth. After collecting the rent and paying all expenses (mortgage interest, council rates, property management fees etc) you are $5000 out of pocket for the year.
That’s a loss of $5000! Money spent…gone.
After claiming your tax deductions, you receive a $2000 refund. Wow! Thanks Mr Government for giving me this free cash!
$5000 minus $2000 is $3000 which is your actual loss for the year. That is still $3000 down the drain.
You buy a property in a good area which has the potential to achieve 10% pa capital growth. After collecting the rent and paying all expenses, you have made $2000.
After adding it to your annual income and doing your tax return, Mr Government says “well we need a bit more money from you due to this extra income”. You end up paying an extra $500 tax for the year.
$2000 minus $500 is $1500 which is your net income gain for the year. That is money in your pocket to spend or invest in more property!
The effective result on your hip pocket is $1500 minus -$3000 equals $4500 per year.
So you can say that using scenario 1, you will pay less tax. You can go around to your friends and brag “I just paid less tax than I should have! Take that Mr Government” and maybe some of them will be impressed.
You will probably fail to disclose that you actually made less money this year in order to achieve it.
But scenario 2 is the clear winner because, although you paid more tax, it was simply because you were earning more money!
You actually have more in your pocket than if you had chosen scenario 1!
In conclusion, the only reason to go with scenario 1 is if the capital gain potential is more than scenario 2. This will mean you are accepting that you are making a loss in the short term in order to get better capital gains in the long term.
This is fair enough, but it is important to understand the motivation of doing scenario 1.
The final disadvantage to scenario 1, is that if you start to build up a portfolio of a few loss-making (negatively geared) properties, all of a sudden your negative cash flow is quite high and it is now much more difficult to get finance for further properties.
However, if you have a positive cash flow portfolio, you will have increasingly more money to spend on further investments or lifestyle expenses.
Choose your investment strategy wisely.