Property Gearing Strategies

Which is better? Cash positive, Positively geared or Negatively geared.

When purchasing an investment property it is important you understand the effect of each of the three strategies, cash positive, positive geared and negative geared. Over the years many books and many opinions have been offered on the subject and truth be told they all have a role to play. Each is greatly dependant on market forces like rent, price and interest rates as well as tax advantages. Investors may use all three strategies in building their investment portfolio as each strategy may become available at different stages of a property cycle. These strategies are generally used over the long term. Our firm has seen all 3 of these strategies in action and has helped clients obtain a property in all of them. Below, you will find some examples of how the different strategies may work. Please note, whilst the interest rate shown may not be the same today, the concept remains the same. Don’t get lost in the detail!

In the coming examples, we’ll use the following numbers -

•An individual in the 40% marginal rate tax bracket.
•An investment property purchased for $300,000.
•An interest rate of 6%.
•Property running costs (management fees, council rates, water, strata levies etc) of 1.5% of the purchase price.

Cash Positive Property

Cash positive is a strategy that refers to obtaining an excess of income from your investment after outgoings are taken out and prior to taxation. While cash positive is a good form of bringing in some extra cash you do need to remember that you will be required to pay tax on this excess of income and these properties are becoming hard to find.

The main ways you can get a cash positive property are through:

• High market rent.

• Renovation or development to improve rental returns. 

• Contributing a large cash deposit to lower borrowings. 

• Lower market interest rates, which you cannot control.

Traditional cash positive properties are usually found in more regional areas, therefore their capital growth is generally less than that of a negative geared property which is usually situated in city, major regional hub or coastal area. The easiest way to establish if a property is cash positive is to start with totalling the expenses of holding the property on a yearly basis. We’ll use our example property -

As can be seen in below, the $300,000 property would need to be achieving a weekly rent of at least $432 per week just to break even with the running costs and that’s only if the interest rate stays at 6%. It’s not everyday that you can find a property like this and even a slight change in interest rates can change the overall position very quickly

Annual Expenses

Interest ($300,000 loan @ 6%) $18,000

+ Property Costs ($300,000 @ 1.5%) $4,500

= Total Expenses $22,500

Weekly rent required to be cash positive (Expenses of $22,500 divided by 52 weeks)

= $432 per week.

Positive Geared Property

Positive gearing is a strategy that refers to the rental income falling short of covering the total expenses but breaks even or is positive after tax benefits are applied.

One of the main ways you can get a positive geared property are through high tax depreciation benefits, often found in new properties.

This time for our $300,000 example property, we’ll use a realistic market rent of $285 per week and assume tax depreciation benefits of $12,000 to the investor.

Annual Income

Rent $285 p/w or $14,820 per year

Less Annual Expenses

Interest ($300,000 loan @ 6%) $18,000

Property Costs ($300,000 @ 1.5%) $4,500

Net Loss (income less expenses)

($7,680) 

Tax Refund (Net loss of $7,680 * 40% marginal tax rate)

$3,072

Actual Cash Outlay (Net loss from table 2 less tax refund from above)

$4,608 negatively geared

Before tax benefits, the investment property falls short by $4,608 per year (Actual Cash Outlay), so is in fact at this stage negatively geared. We’ll now apply $12,000 worth of tax deductions to include in our calculation.

When the expenses of $7,680 is combined with the tax depreciation of $12,000 the investor receives a tax refund of $7,872 which is greater than the actual cash outlay of $7,680 resulting in a positive geared position of $192 per year. This is why it’s extremely important to maximise every possible tax deduction in a property as it can lower the holding costs to you, the investor. In this scenario the extra cash created is not taxed as in a cash positive property. 

Net Loss (from above)

$7,680

Plus Depreciation

+ $12,000

New Total Tax claim (Net Loss plus Depreciation)

= $19,680

Tax Refund ($19,680 * 40% marginal tax rate)

= $7,872

Actual Cash Outlay (Net Loss above less Tax Refund above)

= $192 Positive Geared per year.

Negatively Geared Property

Negative Gearing is a strategy that provides for writing off the losses incurred on an investment against other earned income resulting in less tax being paid or a tax refund. In regards to property, the Australian Taxation Office allows property investors to offset an income loss (where property costs are higher than property income) against any other income they may receive such as their salary. For this example we’ll assume market rent is $260 per week.

In the table below, the property is negatively geared or costing the client $8,980 per year ($172 per week) before tax depreciation.

When the depreciation is applied the cost per year is cut to $588 or just $11 per week. This shows the effect depreciation can have on negatively geared properties. Typically, newer property will have the

Annual Income

Rent ($260 p/w) $13,520

Annual Expenses

Loan Interest ($300,000 @ 6%) $18,000

Property Costs ($300,000 @ 1.5%) $4,500

Total actual expenses

$22,500

Net loss ($13,520 income less $22,500 expenses)

$8,980

Plus Depreciation (from earlier example above)

+$12,000

Total Tax claim ($8,890 + $12,000)

=$20,980

Tax Refund ($20,980 * 40% marginal tax rate)

=$8,392

Actual Cash Outlay ($8,980 Net loss less $8,392 Tax Refund)

$588

Cost per week (divide by 52 weeks)

$11 per week

When the depreciation is applied the cost per year is cut to $588 or just $11 per week. This shows the effect depreciation can have on negatively geared properties. Typically, newer property will have the most deductions which can lower the cost to hold the property and greatly improve cash flow. 

Property Trading

Most property investors have a long-term strategy for future security or retirement. Trading is generally considered a short term strategy to help you enjoy life today, as you get in and out of the investment in a short amount of time. Whilst property trading is short term and can bring in some extra cash, we believe you must have some foundation properties (long term investment properties) in place first before trying your hand at property trading. We recommend it be used with caution by experienced investors as the wrong structure could cost you thousands in extra fees, taxes and loan costs. Some of the more common property trading options are below.

Syndication

Syndication is a form of investment where more than one party will finance the purchase of a property. This can range from a simple structure involving a group of friends or family members to a more complex arrangement where an investment manager offers the public the chance to buy shares in a managed syndicate.

A key advantage of a syndicate is that you have experts choosing and managing the property. You are able to buy into these syndicates for a small outlay often as little as $5,000, but still benefit from being part of group that may have access to better performing properties and those that you could not afford to buy on your own. Syndications are also often used to purchase development sites, resort or holiday apartments, off the plan penthouse units, or even property management rights to a building such as a hotel/resort.

Put and call ‘Option’ contracts

Often used for ‘off the plan’ purchases and for property development. An ‘Option’ contract gives you the right but not the obligation to purchase a property for a set price at a pre determined date in the future.

For an off the plan purchase, the property may have a long construction time (say over 12 months) and whilst the property was good value when you first saw the plans, upon completion 2 years later the market may have dropped in value leaving you with an overpriced property. In such a case using an option contract, you could walk away from the purchase and incur a smaller cost (the option fee you paid) rather than lose your deposit, have a negative equity position, or be unable to settle the purchase. The reverse is also true as if you believe that the property may increase in value during construction, you could lock the vendor in early at a good price before the property increases in value. This could enable you to on sell the property to another person, taking the profit without having to pay stamp duty.

In the case of property development, you may be eager to lock in a vendor before a development site is sold to someone else, and you may not have the time to do your due diligence. If you used an option contract you could lock in the vendor but give yourself time to adequately assess the site and ensure you could build what you wanted to on it – and if not, withdraw from the purchase and only lose the option fee paid. This is a great way to secure a development site but give you time to decide how to best use it to make the most profit.

Buy, renovate and sell

This could be used to describe a situation where you buy a run down property and add value by fixing it up. This could be in the form of new kitchens, bathrooms or as simple as a coat of paint. Once you have added the value to the property you can either sell it for a profit (market dependant of course) or hold the property and borrow against the increased equity. You need to be aware of tax implications if you intend to sell as you wont get a discount on your capital gains tax if you buy and sell within a 12-month period and make a profit. (Assuming you purchased in your own name - see the Tax and Asset Protection chapter for more).

Buying and selling ‘Off the Plan’ without owning the property.

This is where you commit to purchasing a property before it is constructed then, when the property is nearing completion you on- sell the property to someone else for a profit. An experienced investor should only use this strategy with appropriate tax strategies in place as poor timing, a down market or an overpriced purchase to begin with could cause a lot of problems when you go to re-sell towards the end. ‘Off the plan’ strategies are discussed in greater detail in the next chapter.