It has been a while since the last since Australian investment property attracted as much attention as it does last few weeks. As it seems, with the upcoming changes in economical conditions, investors old and new are once again setting their sights on the property market. And so I thought this may be a good time to refresh our minds about some popular approaches to property investing in Australia.
Negative gearing
Negative gearing means that your property is on the day to day basis actually losing money. The profits are made from the increase in value of the property during the time an investor holds it. Obviously, to realize such profits the property must be sold once/if its value increases to desired level.
Example:
Property purchased for $300,000 with 20% deposit and 7.5% p.a. interest only loan renting for $300 per week.
Yearly rental: $15,500
Less yearly interest: $18,000
Less other expenses (maintenance, body corporate fees, council rates etc.) $3,000
Yearly cash return: - $5,500
This technique works best for investors who can offset their ongoing day to day losses from holding this property against the tax they pay on another income. Higher the tax bracket the investor belongs to based on his other incomes, more can be offset against his property loss.
If all the other incomes put the investor into 40% tax bracket, he will receive $2,200 back to offset the loss on his negatively geared property. This means that his cash position for holding this property after one year will be - $3,300
Making profit:
Say it a fairly average year so the properties in the area increase in value by about 7%. This means that, on the paper, our negatively geared apartment is now valued at $321,000. Therefore if sold:
Proceeds from sale $321,000
Less deposit paid on purchase: $60,000
Less outstanding loan $240,000
Less day to day cash loss $3,300
Gross profit: $17,700
This is a simplified explanation of the negative gearing approach. As you can see the investor needs to meet the ongoing losses from from his own pocket and is effectively placing a bet on rising trend of the property values in order to make the profits.
Positive gearing
Positive gearing is fancy buzzword for a basic investing strategy easily understood by everyone. Positively geared property is producing more cash to the investor than it costs him to run it. Nice and simple, find enough positively geared properties and you may retire the day after. The problem is that this type of property is fairly hard to come by.
Example:
Property purchased for $150,000 with 20% deposit and 7.5% p.a. interest only loan renting for $300 per week.
Yearly rental: $15,500
Less yearly interest: $9,000
Less other expenses (maintenance, body corporate fees, council rates etc.) $3,000
Gross profit: $3,500
This technique will work for anybody lucky or savvy enough to find such an investment. To make money, the property does not need to be sold, the investor only needs a reliable tenant paying the rent in timely manner. If chosen wisely, property like this will not only provide the investor with cash surplus year after year, but it will also continues grow in value providing for additional profits should he decide to sell.
As no loss exists, the cash generated from this investment will need to be taxed at one’s marginal rate, same as any other income.
Positive cashflow
Positive cashflow strategy may be somehow difficult to grasp at first. It can perhaps be thought of as negative gearing (ie. property losing money form it “day to day operations�) which, with the help of some perfectly legal tax deductions, turns positive cash returns.
Important thing to remember - with this strategy few more important factors come in play:
- date of the property was built (properties built after 1987 providing for bigger claims an investor can make to the tax office)
- other depreciable items (additional claims could be made to the tax office for number of various items in the property eg. carpets, aircons, etc.; this is where a document known as Depreciation schedule comes in handy)
- investor’s tax rate (for two different investors, same property can be both cashflow positive for one and cashflow negative for the other depending on their marginal tax rate)
Example:
Property purchased for $220,000 with 20% deposit and 7.5% p.a. interest only loan renting for $300 per week.
Yearly rental: $15,500
Less yearly interest: $13,200
Less other expenses (maintenance, body corporate fees, council rates etc.) $3,000
Gross profit: -$700
So far nothing much different from the negatively geared scenario. As it looks now our investor will need to come up with $2,500 from his own pocket just to make up the difference.
Making profit:
However watch what happens once some smart accounting come in play:
Building built after September 1987 so the cost of its construction can be claimed back from the tax men (ie. depreciated) at the rate of 2.5% over the next 40 years. In our case the investor claims 2.5% of $125,000 ie. $3,125 here and additional depreciable items exist totalling to another $2,375.
The depreciable total (while not paid out by the investor) is in Australia legally deductible from other investor’s income hence reducing his total taxable income by $5,500. Because even after such reduction, our investor is still within the 40% marginal tax rate, in effect he is being refunded 40% of the claimable $5,500 giving him additional $2200 in profits from his property.
This amount coming back from the tax office than fully covers the day-to-day loss from the property and actually leaves the investor with $1,500 profit.
As you can see this strategy does have its merits, however it may prove rather tricky to execute. Before investing, one must do a thorough research to obtain reasonably accurate estimates of all depreciable items as well as generate substantial other income (higher tax bracket better) allowing for bigger tax refunds on his claims.
Few closing words:
All the items I named gross profits would obviously still need to be taxed depending on the investors tax situation and the investment holding period. Also, I am aware of omitting some significant purchase and sales costs which would play a significant role in each situation. As all the strategies were described in fairly simplistic manner, if you are new to all this, you will need to do some more in-depth research before proceeding with your property investing carrier any further.
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