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Negative Gearing Revealed

I Need to Invest Now to Save Tax – Negative Gearing Revealed!

Our Armchair Developer approach generates a lot of interest but we sometimes find people who don’t fully grasp the multiple advantages it offers over, other, more standard property investing.

One of the most often made comments focuses on the need to ‘save tax.’ Let’s tease this comment out in some detail so our clients can make informed decisions.

I’ll start by saying, “Investing to save tax really doesn’t make sense.”

Our tax system is structured in such a way that you need to spend a $1 to get an ever diminishing portion of it back. At the highest marginal tax rate (over $180K) a tax payer only receives a refund of 45c for every $1 they spend.  By way of comparison, an average wage earner (approx $73K) only receives a 32.5c refund for every $1 they spend.

If you’re not big on numbers think of negative gearing for the sole purpose of saving tax this way!

How long will you give a mate a $1 and allow them to return less than 45c back before you realise you’re going backwards financially? You can always hope you’ll get your money back and retain a friendship – but there are no guarantees.

Clearly this is not the whole story as potential capital growth needs to be considered.

The problem is, capital growth in property is not a given.  When the market is flat, as it has been for a few years – it is a bit like giving a $1 to your mate, hoping you’ll get it back ‘one day.’

Now that is the snapshot look at our tax system and negative gearing.

Let’s, now, compare two properties, an Armchair Developer property and the same property bought complete. For the purposes of this exercise I have used the feasibility results of a 2 bedroom unit in our Charles Street project.

After Completion Comparison

Armchair Developer Property Standard Purchase
Value $530,000 $530,000
Loan $400,000 $558,000*
Interest Bill @ 6% $24,000 $33,480
Est Rates, Body Corp, etc $5,860 $5,860
U/f Rent @ $550/wk $28,600 $28,600
Annual Cashflow -$1,260 --$10,740
Weekly Cashflow -$24 -$206
After Tax Refund Cashflow -$850/ann -$7,250/ann

The end result is, our Armchair Developer investor is $182/week (before tax) better off when the project is completed.  After considering any tax refund this figure changes to $123/week.

Obviously the standard property is bought completed whereas our Armchair Developer requires an initial ‘buy in’ investment of $139,000 with full ownership about 18 months away.

So let’s take a closer look at what happens during the construction, assuming the initial ‘buy in’ is sourced from line of credit funds.

Before Completion Comparison

Armchair Developer Property Standard Purchase
Value $530,000
Loan $139,000 $558,000*
Annual Interest Bill @ 6% $8,340 $33,480
Est Rates, Body Corp, etc Included in project costs $5,860
U/f Rent @ $550/wk Nil $28,600
Annual Cashflow -$8,340 --$10,740
Weekly Cashflow -$160 -$206
After Tax Refund Cashflow -$5,630/ann -$7,250/ann

From a cashflow perspective alone, during construction our Armchair Developers are $46/wk better off (before tax) and $31/week after tax.

You may be thinking the interest incurred on the $139,000 ‘buy in’ is not deductible because the property isn’t yet complete and earning an income.

I am not an accountant, but some years ago the ATO ruled that deductibility of interest was also determined by the purpose for which the funds were used. In this case the funds were used to purchase an income producing asset so therefore the interest should be deductibility – even during construction.

Before you race off and make investment decisions based on this information make sure you check with your accountant, After all they are qualified to give tax advice.

Let’s get back on track and leave the debate on tax ‘benefits’ to one side for a minute and get back to the reason people invest; to increase their wealth position.

The underlying reason people invest is to increase their wealth position – this is where our Armchair Developer concept wins ‘hands down’ as our clients can reasonably expect a ‘paper profit’ of $130,000 when the project is completed. By way of comparison,  a standard investor needs their property to increase in value by approximately 30% to $688,000 to realise the same gain.

N.B.       Both scenarios

*        Assume purchasing costs are borrowed.

*        Non-cash deductions for depreciation have been omitted as they will be the same for each property and are not known.

*        Assume income of $73,000/annum.