One way of reducing the cost of a home is to get a tenant and the taxman to pay it off for you. This is known as ‘negative gearing.’ Negative gearing is jargon for borrowing to buy an investment where the expected assessable income is less than the expected deductible interest cost, with a resultant net deduction against the owner’s salary income (or other assessable income as the case may be).
An example may help. One of our clients, Lucy, bought a $400,000 apartment in early 2009. It wasn’t where she wanted to live (further away from the harbour than she really wanted), but it was a nice apartment, had good security, was well located and had excellent capital gain prospects. It was also very rentable.
Lucy is a doctor. We arranged for Lucy to borrow 100% of the purchase price, ie $400,000 plus a bit of stamp duty, at 6% interest from a medical specialist-lending group.
Lucy received the first homeowners’ grant and lived in the apartment for 6 months. She shared with a friend and received $135 a week board (ie half the market rent), which was all tax-free in Lucy’s hands. Lucy eventually took a position in a regional hospital and rented the home out to some reliable tenants – people she had worked with in the city hospital. They are still there and pay Lucy $270 a week, or $14,000 a year.
The $14,000 a year is not enough to cover Lucy’s $24,000 a year interest bill. But Lucy can claim the shortfall, ie $10,000, as a deduction in her tax return. With overtime Lucy is earning nearly $100,000 a year, which means she is in the 37% marginal tax bracket, and the rental loss generates a $3,700 extra tax refund each year.
Lucy also claims $5,000 building allowance, and $5,000 depreciation each year (including her share of the elevator and other common plant and equipment). These two deductions generate a further $3,700 extra tax refund each year.
Lucy’s total tax refund is $7,400. This almost covers the $10,000 gap between rent and interest on the loan. Lucy can easily pay the $2,600 shortfall. And provided that the property increases by more than $2,600 in capital value, she will make money.
Lucy’s apartment is now valued at $500,000, so she is off to a good start. Lucy is glad that she bought her apartment when she did. She will probably never live in her apartment again (too far from the Harbour). But she will probably keep it forever as a core investment. And Lucy can borrow against it for her real home down the track. She is well on her way to financial independence.
Lucy was lucky because her parents were prepared to guarantee the loan for her, meaning she did not have to wait a couple of years, and miss a couple of years of capital gain, while she saved a deposit. Using a medical specialist lender made sense: they understand doctors’ income profiles and are aware that doctors are excellent risks for banks, and almost never default on loans.
But Lucy still did it all herself and has the satisfaction of knowing this.