Negative Gearing _____________________________________________________________________________________ What is negative gearing? Negative gearing is a strategy whereby you or your company borrows money to invest in assets that earn income and have a strong likelihood of increasing in value over time, for example, borrowing to buy shares or a rental property. The term ‘negative gearing’ arises where the interest paid on a loan to purchase an asset, is in excess of the income earned from that asset. The difference between the income earned and the interest paid produces a negative result and then is said to be ‘negatively geared’. Depending on your circumstances, the excess you pay on the loan over and above the income earned from it, may be tax deductible and can be used to reduce the tax payable on your other assessable income. What are the advantages of negative gearing? Borrowing money to increase your investments is a way of speeding up wealth creation as you have more money working for you You can prepay up to 12 months worth of interest and claim a tax deduction for the entire amount. This allows you to bring forward expenses that would have otherwise been incurred in the following year (when your income levels may be low) into the current income year Eg. An investor takes out an interest only loan of $100,000 on 1 June, 2005 at a rate of 7% pa. The interest cost for 2005/2006 financial year would be $7,000. By pre-paying this interest cost in June 2005, the investor can claim $7,000 as a tax deduction in the 2004/2005 tax year. An investor at the top marginal tax rate of 47% would receive an immediate tax saving of $3,290. Investors in lower tax brackets would also receive a significant, although smaller, tax saving You may be entitled to a tax deduction of your expenses related to the investment. If you are in on the maximum marginal tax rate, the deduction is worth 47% (does not take into account medicare of 1.5%) The income from the investment may be concessionally taxed due to 1. Franked dividends in the case of share investments; or 2. Building allowance/depreciation deductions in the case of property investment A capital gains tax exemption of 50% applies where an investment has been held for at least 12 months, which means the maximum tax paid on a capital gain is 24.25% (provided the taxpayer is an individual. There is no capital gains tax relief available for a company). A capital gain does not arise until the asset is sold, therefore you can manage your tax liability by selling the asset in a year when your other income is low (ie. When you are on a low marginal tax rate) or can be offset against other assets sold have made a loss. What are the disadvantages of negative gearing? Gearing does carry a level of risk because it requires borrowings to fund the acquisition. The loan repayments must be paid regardless of the investor’s situation. It is important to ensure you have the ability to meet repayments under all circumstances. There are strategies to ensure a large percentage of your salary income continues via Income Protection Insurance should you become sick or disabled. Gearing is not suitable for everyone because it relies on strong cash flow to meet the expenses that are in excess of the income earned on the investment. The deficiency has to be funded from other income such as salary. It should be noted that where property is concerned, some of the expenses that are tax deductible do not involve an outlay of cash. Depreciation and building allowances are examples of these non-cash items and they partially explain the attraction of property as an investment. Geared shares do not provide such non-cash deductions but does provide the benefit of franking credits. Investors need to gear conservatively when investing in shares to ensure that no margin calls are made. Alternatively they need to have the resources to meet a margin call through excess borrowing capacity on their home or other assets held. A Margin Call on negatively geared share plans occurs when the value of your portfolio falls to such an extent, that it is no longer sufficient to secure the Margin Loan. If this occurs, you will need to have a contingency plan in place to keep the loan to security ratio at required levels specified by the lender. The options available when a margin call occurs are usually to Reduce the loan balance by depositing cash Reduce the loan balance by selling investments Lodge additional managed funds, shares or cash as security If you do not respond to the margin call within the specified time limits, the lender will have the right to sell sufficient security to clear any overdue amounts so that the loan to security ration required is restored. Gearing will increase any losses made from an investment. Further to this, capital losses cannot be offset against income. They can only be offset against capital gains. Where income is being relied upon from rent to be received from tenants, it is necessary to consider the means by which you will meet the property outgoings should the tenants default or vacate. Consideration also needs to be made with regard to possible rental vacancy factors in the location of the investment property because this may affect the means by which loan repayments can be met. A negatively geared investment does provide tax benefits to the investor, however, these benefits are of no use unless the value of the investment increases by more than the after tax cost of financing that investment.
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