The investment decision taxpayers make impinges, not only on the taxation consequences, but also onthe asset choice of investment. The transaction cost of investing must be consider as it determines the length of the time the property is held to recoup these costs. Transaction costs are made up of stamp duty on purchase, solicitor or legal cost, borrowing cost; selling cost including property agent commission.
The ‘negative gearing’ aspect of an investment property concept is the ability to offset losses made on the rental property to ordinary assessable income in the form of wages and salary. The ‘assessable income’ earned from the investment property is less than the allowable deductions in the form of interest, strata levy fees, council and water rates, insurance, repair and maintenance, bank fees, borrowing cost, legal fees, property agent fees, and any other cost associated with the property.
The concept of ‘negative gearing’ will work more effectively, or to its maxim in circumstances where one property, normally the family home, is securing the loan over the rental property. The investment property will be able to borrow up to its maximum capacity, including legal and stamp duty cost, claiming all the interest as a tax deduction against the rental income. The largest component of tax-deductible expenditure is interest paid on the investment loan.
See the following example:
Investment Property – Profit & Loss
Interest (loan $350,000)
Repair & Maintenance
Special Building (write off)
Total Rental Exp
Profit/Loss Rental Activity
The loss incurred as a result of the rental property activity is off set against assessable income. For example, a taxpayer on a salary of $125,000 will pay income tax of $36,075 (2011 tax rates), however, the rental activity loss is off set against the assessable income reducing it down from $125,000, less $25,937, to a reduced taxable income $99,063. The amount of income tax payable on $99,063 is $26,089, a reduction in tax by $9,986.
The tax affect or ‘negative gearing’ is brought about by the amount of interest paid on the loan of $350,000.Most rental property investors pay principle and interest off their loan, thus reducing the tax deductibility, as there is less interest claimable at lower levels of principle. Take for example the loan when it is reduced to $300,000, interest is also reduced to $21,750; therefore the tax effect decreases by $1,758.
The further the loan is reduced, the less, and less interest that can be claimed as a tax deduction against rental income. Eventually, the rental property will become ‘positive geared’ where income exceeds expenses as the property has a net profit that adds to assessable income and tax is levied according to the taxpayer’s marginal rate.
A new investment property has distinct advantages, over an older property, because the taxpayer can claim depreciation on items such, as white goods, carpets, lighting, and the like, as well as the special building write off allowance of 2.5% (Residential) over 40 years. These non-cash tax-deductible items add to the appeal of an investment property as a tax effective investment as they offset assessable income without outlaying any extra cash.
The out of pocket expense to hold the investment property in the above example, taking into consideration the tax effect, adding back depreciation, special building write off, the amount the investor must contribute each year is $6,097.Most investor hold residential, or commercial properties, not because they are just tax-effective, but to realise huge capital gains as the property increase in value over time. The gains on an investment property, in circumstances where a taxpayer owns more than one property, are subject to Capital Gains Tax.
The method in assessing the capital gain or loss is to take the purchase price, plus transaction cost, offset against the sale price, allowing for transaction cost on disposal. Capital Gains Tax is only payable on 50% of the gain in situation where the property is held by an individual, trust or partnership. The capital gain is then added to the assessable income of the individual to which his or her marginal tax rate is applied, plus medicare levy, in ssessing the amount of tax payable