Fundamental Focus: Negative Gearing, Backwards Thinking Tuesday, June 22, 2010

Figures from the Australian tax office reveal that 1 in 10 Australian tax payers own property that is negatively geared. That is, there are 1.2 million Australians who are spending more on their investment property than what they are generating in income. Moreover, this hasn’t been an accident of circumstance; these investors have for the most part specifically constructed things in this way.

This may seem like a bit of voodoo economics, but it actually makes sense if you assume that the eventual capital gains will be more than enough to compensate investors for any losses occurred along the way. People also argue there are real tax benefits along the way.

As is often the case, the best way to explore the situation is with an example.

Meet John

Consider John, who earns \$100,000 per year. He has purchased a property for \$500,000, 90% of which was funded through a mortgage (i.e. he borrowed \$450,000). His tenants pay him \$500 per week, or \$26,000 annually and he pays interest on his loan at 7%. (With investment properties, you are able to claim your interest as a tax deduction. To keep things simple, and generous, I have not included rates, maintenance, agents fees, insurance costs etc.)

His taxable income is therefore \$100,000 (salary) + \$26,000 (rental income) - \$31,500 interest = \$94,500

Under the current tax scales, that means he has to pay \$23,360 in tax leaving him with \$71,140 as an after tax income.

Now if John didn't buy the property, and instead put his deposit (\$50,000) into an interest bearing account, he could have received around \$2,500 in interest (assuming 5% pa). Combined with his salary, this gives him a total income of \$102,500. He will need to pay \$26,400 in tax leaving him with an after tax income of \$76,100.

To summarise:

 Investment Property Cash in bank Taxable Income \$94,500 \$102,500 Tax Payable \$23,360 \$26,400 Net Income \$71,140 \$76,100

So we can see that John certainly paid less tax under the negative gearing scenario. The problem is that he also generated a lower net income! It’s like cutting off your nose to spite your face. Personally, I’d prefer to pay more tax if it meant that I got a higher after tax income.

But of course John may be prepared to have a lower net annual income each year if he can eventually make a good return on his property. After all, if his property grows by 10% each year, he stands to make a capital gain of \$165,500, or \$134,055 after tax after just 3 years. In this scenario, who cares that his net income was reduced by almost \$5,000 each year? Ultimately, it was worth it. Moreover, he has done this with just \$50,000 of his own funds; that’s an annualised return of roughly 36% per year!

This is why negative gearing is so popular. Although you must service costs along the way and suffer a lower income, you stand to make a very good return on your initial investment capital, because of the tax deductibility of interest payments. It also has the potential to reduce your tax by pushing you into a lower tax bracket. What’s more, if you hold your property for over a year, you pay tax on only half the gain.

The Dangers

But before you take on a big mortgage and rush out and buy an investment property, understand that this strategy is far from fool proof. The biggest assumption that people make is that property always goes up. It is an understandable misconception: a mix of undersupply, population growth and economic prosperity have helped drive residential property consistently and aggressively higher in recent times. But as we have seen elsewhere in the wake of the GFC, property is no more guaranteed to go up than is the share market (residential property has declined by roughly 30% over the past few years in the US).

Let’s assume that instead of growing by 10% each year, John’s property actually experiences a 10% decline in the first year before growing at 5% and 10% in the following two years.

 Starting value \$500,000 Year 1 \$450,000 Year 2 \$472,500 Year 3 \$519,750

The after tax capital gain, here is \$15,997.50. Had he left his deposit money in an interest bearing account, he could have made \$15,116 over three years, after tax. So the entire exercise has barely been worth the effort. In fact, when you consider the investment risk profile of property against cash, an economist would argue that it has in fact been a very unfavourable scenario! Also let us not forget that we have only included the interest expense and have ignored rates, insurance, agent fees, maintenance costs etc.

The second mistake people make is to forget that interest rates move; sometimes very quickly and unfavourably. Since October of last year we have seen an aggressive tightening cycle, with the official cash rate rising by 150 basis points. For a \$450,000 loan, that's an extra \$6,750 in interest each year. Tax deductable or not, that has to be serviced and it has the potential to seriously impact John’s quality of life. If things get tight (maybe John becomes unemployed for a few months or suffers a pay cut) John may be forced into selling his asset much sooner than he would have liked, and potentially at a time when house prices are not favourable.

A Better Way

By now we can see that a strategy of negative gearing only makes sense if:

1. The eventual capital gain is sufficient to recover all losses along the way (far from certain)
2. You are able to tolerate the drop in net income along the way
3. There is no significant change in your capacity to service the loan

Also, it is critical to understand that the lower tax liability has come as a result of lower earnings. If you think lower after tax earnings is a good thing in and of itself, then you might want to talk to your accountant.

But you don't need to suffer a loss in income, you can actually have the best of both worlds with positive gearing. That is, you can increase your net income each year and magnify your gains through the gearing process. Plus it’s possible to achieve far superior tax benefits without having to lower your net income. Be warned though; it involves investing in the share market, something that everyone knows is volatile and very high risk, right? Well not necessarily, especially if we can approach the market with the mindset of a property investor. That is, looking to generate an income along the way and with an investment horizon of years, rather than weeks or months.

Property investors will quite happily borrow up to 90% of the value of their property without hesitation, and when you are talking about capital city house prices, you are talking well over half a million dollars. But when it comes to the share market, even a small borrowing is considered high risk by most people.

Let’s assume that John invests his \$50,000 into the market and borrows another \$50,000 from a margin lender. With \$100,000 to invest, he is geared at 50%. As with investment property, the interest on a margin loan is tax deductable. His interest rate is 8% (margin loans tend to charge a higher rate of interest). Finally, we will also assume that he invests in dividend paying shares with an initial yield of 4.5% (the current average for the ASX 200 is 4.7%), and that these stocks pay fully franked dividends.

This means that John will generate \$4,500 in dividends each year, plus about \$1,928 in franking credits (more on this in a moment). Of course he has to pay interest on the \$50,000 loan, which is \$4000.

So John’s taxable income is \$100,000 (salary) +\$4,500 (dividends) +\$1,928 (franking credits) - \$4,000 (interest) = \$102,428.57.

He has to pay \$26,373 in tax on this, but the franking credits also act as a rebate, reducing his tax liability to just \$24,444.07. He therefore has an after tax income of \$77,983.93.

To summarise:

 Margin Loan Cash in bank Taxable Income \$102,428 \$102,500 Tax Payable \$24,444 \$26,400 Net Income \$77,983 \$76,100

So in this scenario John is positively geared; that is, his assets have generated more in income than what they cost. Unlike with property there are no additional costs; no council rates, no insurance, no maintenance or agent fees – nothing!

Plus, the tax benefits are far greater; although he earned essentially the same as he did under the cash investment scenario (based only on dividends), his tax liability is close to \$2,000 or 7.4% less! The point to drive home here is that this scenario John has received a benefit from holding his assets and is not dependant on an eventual capital gain to make for any costs. His net income has increased and he still has the potential of a future capital gain.

This of course the fact that the share market is very volatile, certainly more so than property, and short term losses can be rather severe (Between November 2007 and March 2009, the market lost 54%). However these are of little concern for the long term investor, especially one who can afford to make regular contributions and reinvest dividends. (Read almost any of my other articles if you need evidence of this).

Some may argue that the property investor would still be better off: for every 1% rise in the value of the asset the property investor makes \$5,000 as opposed to the \$1,000 (gross) that the share investor makes. This however is a consequence of a higher gearing ratio (90% versus 50%). The thing to remember though is that a higher gearing not only magnifies your gains by a greater extent, it also magnifies your losses. Of course, the share investor could have chosen to gear at a higher rate if they wished, usually up to 70%, but given the volatility of the market and the consequences of a margin call, this is a high risk play. And despite what property investors tend to think, a 90% gearing level for an investment house is still reasonably high risk.

In fact the only disadvantage with shares is their volatility, but again this shouldn’t be a major concern for those with an investment horizon of at least 5 years. Especially, if the shares owned are reliable dividend payers. As I have said many times before, the price of your shares matters only when it comes time to sell, in the meantime the only consideration is the level of dividends.

Had you invested into the market 5 years ago today, and let us assume you achieved only the market average, you would today be sitting on a gain of over 33% with dividend reinvestment. Not bad given we have just experienced the worst financial disaster since the Great Depression, and considering we remain well below the market’s all time high.

Summary

So negative gearing certainly has a dark side, and things are not guaranteed to work in your favour. A positively geared scenario is usually the better way to go, and wherever possible investors should aim to structure things in this way.

For those interested in gearing, the share market offers great potential. Not only is it easier structure your gearing in a positive way, but you can receive very favourable tax treatment and expose yourself to excellent long term gains. Despite what many people think, margin lending isn’t as dangerous as it is often portrayed. Those with a well balanced portfolio of quality dividend paying stocks, and who gear to appropriately have significantly less risk than would otherwise be the case (e.g. A 50% geared portfolio must drop by over 30% before a margin call is triggered).

Make the markets work for you!

Andrew Page
Optionetics.com.au
Optionetics.com ~ Your Options Education Site