Investing: Rental Properties – The Financials Part 2

If this is the first of these articles that you are reading, you can still catch up. First there was an article on how to conduct research to find a suitable property. Next there was an article on purchasing and financing a rental property.

This article is about the everyday financials of a rental property. One topic needs special attention.

Gearing

When you are researching for a suitable rental property to purchase you may come across “advice” about the merits of gearing. Or more probably the worthiness of negative gearing. Less often you will hear about positive gearing.

Gearing simply means borrowed money. The amount of borrowed money can be any amount but with a rental property is typically around 80% of the purchase price. So if gearing is borrowed money, what are positive gearing and negative gearing?

Rental properties earn rent income. Rental properties also have various expenses such as rates, insurance, repairs etc. If money is borrowed to purchase the rental property there is also interest payable on the loan. Positive gearing means that after rent expenses and interest are deducted from rent income, there is money left over, a rental profit. Negative gearing means that after rent expenses and interest are deducted from rent income, there is a rental loss.

Where a property is negatively geared, the shortfall must be made up by other sources of money ie savings or income from business or employment.

Some people get excited by the prospect of a negatively geared property because they believe the shortfall will be made up through the taxation system. This is only partially true. It is true that a rental loss can be offset against other income (eg wages), so that less income tax is paid than there would be without the rental loss. However your income tax is only reduced by your marginal rate of tax. Let us use an example:

A has annual wages of $60,000. A’s rental loss on his investment property is $5,000. A’s taxable income is $55,000 and his marginal tax rate is 31.5%. The income tax that A “saves” by having a rental loss is $5,000 x 31.5% = $1,575. So, even after the saving in income tax, the net rental loss is $5,000 – $1,575 = $3,425.

So negative gearing is not the nirvana that some people would have you believe. You need to pay out a net $5,000 during the year to get a $1,575 reduction (or refund) in your income tax when you lodge a tax return to end up with an out of pocket cash loss of $3,425.

On the other hand, a positively geared property gives you net income from the outset. Sure, you will lose some in income tax but again the tax on the rental profit is only at your marginal rate of tax. In the example above, the marginal rate of tax is 31.5%.

So, WHY would you put up with a property that regularly makes a loss? First, the plan should be not to make a loss forever. Property is a long term investment,  NOT for just a year or two. Over time rent income should increase and as part of the loan is paid off interest paid reduces, so the rental loss should over time become a profit. Second over the long term, if you have bought a good property, the value of the property should go up. If you sell the property at a later date you plan on collecting a capital profit, which should ideally more than offset the earlier rental losses.

There will be one final article on the nitty gritty of the financials of rental properties.

 NOTE: Tom On Tuesday IS a CPA but is NOT a tax agent, a financial planner, a banker, a stock broker nor a real estate agent. Please note that all blog posts written on financial matters should not be taken in any way as advice from Tom On Tuesday. This blog post contains general information and the opinions of Tom On Tuesday. This general information also only pertains to Australia. Anyone reading this blog should seek out professional advice for their own personal circumstances before making any decisions.

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