Negative gearing has been prevalent in Australia since 1936 when the Federal Government introduced it in its Income Tax Act. It has very easily been one of the most potent tax planning strategies for the rich and middle class income earners.
The strong Australian economy has not experienced a recession since the early 1990s (a brief downturn caused by the global financial crisis in 2008 did not technically amount to a recession). This along with real rising incomes, low interest rates, and rapid increases in property values, has delivered an economic environment conducive to negative gearing
The quantum of benefit from negative gearing (if done correctly) far exceeds any other means of tax minimization that is currently available in Australia. Unlike other strategies, it is not only a tax minimization strategy but it is also a wealth creation strategy.
Negative gearing primarily requires you to borrow money to buy and then rent out an investment property to a tenant, where by if structured correctly can show a substantial rental loss (many times its only a small or book loss, as the major allowance is for the depreciation of the property).
It is particularly tax efficient because while the rental loss is 100% tax deductible against your other income earned during the year, the capital gain (assuming there is one) will only ever be taxed at half your marginal tax rate, if you hold for more than one year and then decide to sell it. Unrealized Capital gains are not taxed. In a way it is a deferred tax debt benefit provided by the ATO, for you to grow your asset base.
When you run the numbers on this, the amount of return you need on your growth investments is less in a simple percentage term than the interest rate on your loan.
Previous negative gearing has been tried with Shares and Managed Funds, even though in principal it works the same way, but the impact can be completely adverse.
Volatility is the biggest enemy of Shares / Managed Funds and can result in losses that exceed the loan valuation ratios (LVR’s), whereby resulting in Margin Calls.
You do not need to take your mind far back, just remember during GFC in 2007 when markets fell by 40% and investors were getting margin calls.
Having said that, it is important to note that negative gearing on investment properties has its loopholes.
There is a requirement to borrow at appropriate gearing levels, at reasonable interest rates, in right properties that will grow in value over time. Therefore it requires experts who can understand and integrate the whole strategy. As you can see if any if these pieces fall out of sink, it could be a disaster.
Even though the tax benefit is immediate for the client when they claim the deduction, the turbo effect of the leveraging will only play out if the client is invested in the right property.
There are other tax minimization strategies that can be considered but some of them are now being impacted by legislation.
Within superannuation, there have been changes in the legislation that that have literally taken out the advantage of any additional tax benefit. For long, investors have looked at taking benefit of the favorable lower 15 % tax environment in superannuation and were encouraged to move their personal income from higher marginal tax structures into the lower superannaution environment by executing strategies like salary sacrificing and transition to retirement.
However with the changes proposed at reducing the concessional contribution cap to $ 25,000 from July 2017, the impact has been reduced further. After claiming the 9.5% employer contribution for middle income or high-income earners as part of the cap, there is limited capacity to execute these strategies. Also post July 2017,all earnings in Transition to Retirement mode will be taxed at 15% that further impacts the wealth creation option for the fund.
Other strategies like structuring ownership of assets effectively can work depending on personal situation but say, if you are having an income split through your discretionary trust where higher distributions are made to low members with lower tax rate, it will always be a matter of time when their incomes will grow and the previously low income earner will have to pay more tax. So it becomes an annual strategy to evaluate/change and not one that can sustain any wealth creation.
Even salary packaging has its issues related to fringe benefit tax that employers are reluctant to pay and even things like novated leases for car, though look simple, many times they are difficult to execute as it requires consent of employer and a third party financer.
Work Related expense deductions also have strict ATO rulings and require a good paper/document trail. These in terms of materiality are not generally much but to a specific situation could be substantial. Then we have benefits of time deductions like prepaying interest on loan or insurances. These again can be very cyclical.
Finally, the intention is not to go into all tax minimization strategies possible because there would a few that would work excellent for a specific situation.
However, one can only reiterate that negative gearing is not only about tax minimization but also about wealth creation. It has worked for Australian familes for decades and for many who have created a fortune.
