Negative Gearing and Taxation
What is Negative Gearing?
According to the Australian Taxation Office, a rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.
How does Negative Gearing effect my Tax Return?
The overall tax result of a negatively geared property is a net rental loss. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income - such as salary, wages or business income - when you complete your tax return for the relevant income year. Where the other income is not sufficient to absorb the loss it is carried forward to the next tax year.
Negative gearing by property investors reduced personal income tax revenue in Australia by $600 million in the 2001-02 tax year, $3.9 billion in 2004-05 and $13.2 billion in 2010-11.
Taxation – Australian Residents
Australian tax treatment of negative gearing is as follows:
Interest on an investment loan for an income producing purpose is fully deductible, even if the income falls short of the interest. Any shortfall offsets income from other sources, such as the wage or salary income of the investor.
Ongoing maintenance and small expenses are similarly fully deductible. Property fixtures and fittings are treated as plant, and a deduction for depreciation is allowed, based on effective life. When later sold the difference between actual proceeds and the written-down value becomes income, or further deduction.
Capital works (buildings or major additions, constructed after 1987 or certain other dates) receive a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is on the initial cost (or an estimate), until exhausted. The investor's cost base for capital gains tax purposes is reduced by the amount claimed.
On sale, or most other methods of transfer of ownership, capital gains tax is payable on the proceeds minus cost base (and excluding items treated as plant above). A net capital gain is taxed as income, but if the asset was held for 1 year or more, then the gain is first discounted by 50% for an individual, or 331⁄3% for a superannuation fund. (This discount commenced in 1999, prior to that a cost base indexing and a stretching of marginal rates applied instead.)
The tax treatment of negative gearing and capital gains are generally seen as beneficial to investors for several reasons, including:
• Losses are deductible in the financial year they are incurred, providing nearly immediate benefit.
• Capital gains are taxed in the financial year when a transfer of ownership occurs. If held for more than 12 months, only 50% of the capital gain is taxable.
Transfer of ownership may be deliberately timed to occur in a year when the investor is subject to a lower marginal tax rate, reducing the applicable capital gains tax rate compared to the tax rate saved by the initial deductions.
However, in certain situations the tax rate applied to the capital gain may be higher than the rate of tax saving due to the initial deductions. For example, if the investor has a low marginal tax rate while making deductions but a high marginal rate in the year the capital gain is realised.
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