Negative Gearing or Positive Gearing - do I need to Gear anything in this volatile market?

There's lots of hype when it comes to negative gearing. And this all stems from the fact that quite a number of property sharks make a killing from selling negatively geared properties to unsuspecting investors.

Sadly, a lot of investors are sold on the potential outcome of owning property (hopefully making truckloads of money) without understanding the immediate consequences of their investment. Negative gearing is a strategy that provides immediate tax benefits while also offering the promise of long-term gains in the form of capital appreciation.

Financial definition

Negative gearing is a form of leveraged speculation in which a speculator borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan (Interest > Income). In Australia the strategy is motivated by taxation systems which allow deduction of ongoing speculative losses against highly taxed income, but tax capital gains at a much lower rate. When income generated does cover the interest it is simply geared investment which creates a source of passive income.

A negative gearing strategy can only make a profit if the asset raises so much in price that the capital gain is more than the sum of the ongoing losses over the life of the speculation. The speculator must also be able to fund the planned shortfall until the asset is sold. The different tax treatment of planned ongoing losses and possible future capital gains affects the investor's final return.

Things to look for before you invest:

• Work out your maximum borrowing capacity - Bank or Broker
• Structure your investment correctly - Offset or Collateral
• Understand the best  strategy - investment tax breaks, taxable income and cash benefits - joint property or tenancy in common
• Buy in growth areas and use the equity as it grows - Best house in Worst Suburb or Worst house in Best Suburb.
• Keep your low overheads
• Keep your ongoing costs low
• Minimum Capital - maximum growth
• Make sure the property appeals to the right tenants - close to transport and schools
• Purchase a property that gives you non-cash tax deductions - Brand New for best Depreciation benefits.
• Use cash to reduce other non-deductible debt - stamp duty, borrowing etc.

What can be claimed to accelerate the negative gearing:

• Advertising for tenants
• Bank charges
• Body corporate fees - Strata
• Cleaning
• Council rates
• Electricity and gas
• Gardening and lawn mowing
• In-house audio/video service charges
• Insurance - building, contents, public liability
• Interest on loans
• Land tax
• Legal expenses
• Lease costs - preparation, registration, stamp duty
• Mortgage discharge expenses
• Pest control
• Property agent's fees and commissions
• Quantity surveyor's fees
• Repairs and maintenance
• Secretarial and bookkeeping fees
• Security patrol fees
• Servicing costs, eg: servicing a water system
• Stationery and postage
• Telephone calls and rental
• Tax-related expenses
• Travel and car expenses - rent collection, inspection of property, maintenance of property
• Water charges.

Make sure you understand borrowing expense before you buy - no everything is immediate deduction following is the list of borrowing expense that is amortized.

1. stamp duty charged on the mortgage
2. loan establishment fees
3. title search fees charged by your lender
4. costs for preparing and filing mortgage documents
5. mortgage broker fees
6. fees for a valuation required for loan approval
7. Lender's mortgage insurance, which is insurance taken out by the lender and billed to you.

Amortization Example

On 3 July 2009, Peter took out a 25-year loan of $300,000 to purchase a rental property. Peter's deductible expenses were:

1. $800 Stamp duty on the mortgage  
2. $500 Loan establishment fees
3. $300 Valuation fees required for loan.

Peter also paid $1,200 stamp duty on the transfer of the property title for which he cannot claim a tax deduction. However, this expense will form part of the 'cost base'.

As Peter's borrowing expenses are more than $100, he must claim them over five years from the date he took out his loan for the property. He would work out the borrowing expense deduction for the first year as follows: