11/06/2019 by Pascoe Partners Accountants
With the Reserve Bank’s announcement of an interest rate cut, investors around Australia are wondering how it’s going to affect them.
Assuming that some of this saving is passed on by the banks, the topic of negative gearing raises its head.
In particular, the question of whether negative gearing can be effective in a low interest rate environment?
Below we clear up the question: how does negative gearing work – and can it can work for you as an investor when interest rates are low?
Negative gearing is a position where the income generated by an investment (usually a rental property but it also applies to other investments, such as shares) is lower than the costs of holding the investment.
The excess is tax deductible to the owner. This is the “negative” element.
The holder of the property (or other investment) hopes to win in the long term because the capital growth of the property compensates for the shortfall.
There will likely be capital gains tax on the sale but generally only 50 percent of the gain will be subject to tax.
Note that this was an area that the Labor Party campaigned to change in the lead up to the last election.
Being accountants, we love to look at the numbers.
You should too, if you’re considering the effects of an interest rate cut on negative gearing.
Assume an average house price of $600,000 with a loan of $480,000 interest-only at 4.5 percent p.a., average rental of $350 per week, and other costs (rates, repairs, etc.) of $10,000 per year.
The net rental for the year is a shortfall of $13,400, which is the amount of the tax deduction.
If you have a taxable income of $80,000, you’ll pay $17,547 in tax including the Medicare levy, leaving net cash of $62,453.
If we take into account the shortfall, the taxable income is reduced to $66,600. This means that the tax reduces to $13,192 and the net after tax cash is $53,408.
The reduction in the net after tax cash is $9,045.
So, provided the property increases in value by at least 1.51 percent each year ($9,045/600,000) you would be on the winning side of the deal (excluding the capital gains tax on sale).
Doing the same calculations but using a taxable income of $150,000, the result is a net cash shortfall of $8,442. In this case, a 1.41 percent increase in property value would be necessary to win.
Now you know more about how negative gearing works, it should be clear that it can still work in a low interest environment.
It’s not without risk, of course. As we know, property values do not necessarily increase every year.
But, provided there is an increase over the life of ownership of the property, negative gearing can be effective.
As you would expect, should interest rates increase, the shortfall will increase.
Using the example above (with an income of $150,000), if interest rates increased to say 7 percent, the property would need to appreciate in value by at least 2.67 percent each year to break even.
However, this is a very simplified example. Increasing interest rates would likely lead to increases in weekly rental; but generally there will be a lag between the two and, of course, it depends on the terms of the lease.
The bottom line? Negative gearing can work in a low interest rate environment as much as when rates are higher but it all depends on the capital growth of the property.
The Reserve Bank only lowers rates to such low levels to stimulate the economy, which likely leads to falling (not increasing) property values. Remember, negative gearing relies on rising property values to be effective.
Please also note that we’ve applied an interest-only facility for these examples.
If we were to take into account loan repayments, the cash shortfall would increase and the amount of appreciation required to break even would also increase.
Are you considering investing in a rental property and intending to borrow to finance the purchase?
Contact us for a thorough review of your options.