Introduction
Negative gearing is a widely used investment strategy in Australia, particularly among property investors. This strategy involves borrowing money to purchase an investment property, expecting the rental income generated by the property to be less than the expenses incurred.
The resulting net loss can be used to reduce the investor's taxable income, potentially providing significant tax benefits. A common question is whether negative gearing applies to the mortgage repayment (both principal and interest) or just the interest component. Let's find the answer to this question in this blog using examples.
Key takeaways
- Negative gearing involves borrowing money to buy an investment property where rental income is less than expenses.
- Mortgage repayments for investment properties consist of principal and interest components.
- Accurate negative gearing calculation optimises tax benefits and ensures compliance with regulations.
The basics of mortgage repayments
When you take out a mortgage to purchase an investment property, your monthly repayments typically consist of two components:
- Principal: The portion of the repayment that goes towards reducing the outstanding loan balance.
- Interest: The cost of borrowing the money.
In addition to mortgage repayments, property investors incur other expenses while calculating negative gearing, such as property management, maintenance, insurance, and body corporate fees. These expenses can also be considered when calculating the net loss for harmful gearing purposes.
A comprehensive analysis of whether negative gearing applies to principal or interest
Let’s understand how negative gearing applies to principal and interest with an example below:
Example:
Sarah is a 35-year-old professional living in Sydney. She invests in property to build wealth and secure her financial future. After consulting with her financial advisor, Sarah purchases an investment property and opts for a loan to finance the purchase.
Sarah’s property and loan details
- Purchase price of property: $500,000
- Loan amount: $400,000 (80% Loan-to-Value Ratio)
- Interest rate: 5% per annum
- Monthly mortgage repayment: $2147 (calculated using an amortization schedule over 30 years)
- Principal: $1147
- Interest: $1000
Sarah’s additional expenses
In addition to her mortgage repayments, Sarah incurs the following monthly expenses related to her investment property:
- Property management fees: $200
- Maintenance and repairs: $125
- Insurance: $100
- Body corporate fees: $200
- Monthly rental income: $1500.
Now, let's examine two methods of calculating the net loss for negative gearing purposes.
Method 1: Negative gearing calculation using both principal and interest
- Monthly mortgage repayment: $2147
-
Other monthly expenses:
- Property management fees: $200
- Maintenance and repairs: $125
- Insurance: $100
- Body corporate fees: $200
- Total Other Monthly Expenses: $625
Applying the formula, we get:
- Total monthly expenses: $2147 (mortgage repayment) + $625 (other expenses) = $2772
- Monthly rental income: $1500
- Net monthly loss: $2772 (total expenses) - $1500 (rental income) = $1272
- Annual net loss: $1272 x 12 = $15,264
In this scenario, Sarah might think that the entire $15,264 loss would be deducted from her taxable income. However, this is not the correct approach according to tax regulations.
Method 2:Negative gearing calculation using only interest
This method considers only the interest portion of the mortgage repayment and other deductible expenses. Let’s now understand the calculation:
- Monthly mortgage repayment: $1000
-
Other monthly expenses:
- Property management fees: $200
- Maintenance and repairs: $125
- Insurance: $100
- Body corporate fees: $200
- Total Other Monthly Expenses: $625
Applying the formula, we get:
- Total monthly expenses: $1000 (mortgage repayment) + $625 (other expenses) = $1625
- Monthly rental income: $1500
- Net monthly loss: $1625 (total expenses) - $1500 (rental income) = $125
- Annual net loss: $125 x 12 = $1500
Here, only the interest portion of the mortgage and the other deductible expenses are included in the calculation, leading to a minor net loss of $1500. By accurately calculating negative gearing, you can effectively use this investment strategy to maximise tax benefits and stay compliant with regulation.
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Why only interest?
The principal repayment returns the borrowed capital and does not represent a cost of earning the rental income. Therefore, it is not deductible for tax purposes. The interest component, however, is considered a cost of earning the rental income and is deductible.
When calculating your net rental loss for tax purposes, you should include all the deductible expenses directly related to the rental property. These typically include:
- Interest on the Mortgage: Only the interest portion of your mortgage repayments is tax-deductible. This ensures that you only deduct the actual cost of borrowing the money.
- Other Deductible Expenses: These may include property management fees, maintenance costs, insurance, body corporate fees, and depreciation.
-
Deductible Expenses:
- Interest: $1000
- Property management fees: $200
- Maintenance and repairs: $125
- Insurance: $100
- Body corporate fees: $200
- Total Monthly Deductible Expenses: $1625
- Monthly Rental Income: $1500
Using Sarah's example, the correct negative gearing calculation would be:
Net monthly loss: $1625 (total expenses) - $1500 (rental income) = $125
Annual net Loss: $125 x 12 = $1500
This $1500 net loss is the amount Sarah can deduct from her taxable income, not the $15,264 calculated when including the principal repayment. For more accuracy in your calculations, try using our negative gearing calculator.
Conclusion
Negative gearing applies primarily to the interest component of your mortgage, not the principal repayment. By following the correct method of calculation, investors like Sarah can ensure they are accurately reporting their expenses and optimising their tax benefits. This aligns with legal requirements and aids in making informed financial decisions regarding their investment properties.
For personalised advice and detailed assistance, consulting with a professional tax agent can provide clarity and ensure compliance with the latest tax regulations. At Zedplus, we specialise in helping investors navigate the complexities of tax regulations. Contact us today to ensure you are maximising your tax benefits and making the most informed financial decisions for your investment portfolio. Let our expertise guide you to financial success.