Q: Could you please explain what negative gearing is and how does it work?

A: Gearing is the process of borrowing money to buy an asset. Gearing is often referred to as being either positive, neutral or negative. Positive gearing means the asset purchased produces positive income or cash flow after ongoing costs. Neutral gearing means the income equals the ongoing costs. Negative gearing means the ongoing costs are higher than income and hence produces negative cash flow.

Gearing can potentially be an effective way to accelerate the accumulation of wealth. The benefits of gearing are that larger investments can be made by borrowing than if you were only using your own funds. There is potential for greater investment returns (after taking into account tax and other costs) than would be achieved without gearing and the strategy may also help reduce your ongoing tax liability.

Provided the purpose of borrowing the funds is to invest in assets that generate taxable income, loan interest costs and costs associated with borrowing are generally tax deductible. There may also be potential tax benefits available to offset tax on the investment return.  For example, depreciation on property and furnishing, the 50% Capital Gains Tax discount on the sale of the asset if owned for more than 12 months by an individual and franking credits on ongoing share dividend income.

Gearing exposes you to additional risks that need to be taken into consideration before embarking on the strategy. Gearing increases the investment risk attached to an investment because the borrowed amount increases your exposure to an investment market.

Whilst gearing provides an opportunity to increase gains when markets are rising when markets fall the losses are magnified. This means that although as an investor you might receive extra tax deductions over time, you might actually lose capital value and carry over significant debt when you eventually sell the asset.

Gearing is only appropriate for people with sufficient cash flow and income to meet ongoing borrowing costs. You should only borrow to invest if you have the financial capacity to absorb potential falls in investment values, periods of lower or no rent on a property.  Likewise, you need to be able to weather the impact of rising repayments if interest rates were to rise.

Investors need security of personal income. A loss of income or change in personal circumstances, even if temporarily, could cause cash flow problems that may require the sale of an asset or part of an investment portfolio at an inopportune time which may lead to investment losses.

Gearing makes sense provided the long-term rate of return is higher than the interest costs of borrowing and the costs of managing the asset. The costs of gearing will depend on what type of loan facility you use.  Typically drawing on a residential property loan offers the lowest interest rate cost. Lenders will usually allow you to borrow up to 80% of the value of your property without paying Mortgage Insurance. You need to weigh up the interest costs of the lending facility you choose and the flexibility in loan terms you require.

Ultimately your decision whether to borrow to invest should be governed by how long you intend to invest for, how much gearing you are prepared to take on, how healthy your cash flow is and how much of your capital you are prepared to commit.

Q: I have read that the Labor party are proposing changes to negative gearing and the taxation of Capital Gains if elected.  Could you please explain what is proposed?

A: Under the proposed changes, investors who purchase an investment (with the exception of investments in “new housing”) after 1 January 2020 will be unable to claim losses and deductible expenses from that investment in excess of the taxable income generated from the investment.

Importantly, all investments made prior to 1 January 2020 will not be affected by the changes.

Under current law, Capital Gains Tax (CGT) broadly applies to the disposal of an investment asset acquired on or after 20 September 1985.

In calculating CGT for an individual, you first need to determine the Capital Gain. This broadly involves subtracting the applicable cost base of the asset from the sale price of the investment. The cost base will usually include the purchase price or acquisition value plus transaction costs. This figure is referred to as the Capital Gain. If you have owned the investment for more than 1 year, typically 50% of the Capital Gain is added to your assessable income. For example, you sell shares for $150,000, with a cost base of $100,000, the Capital Gain is $50,000. Therefore $25,000 would be added to the individual’s assessable income.

The Labor party propose to reduce this 50% Capital Gains Tax discount to 25% on the sale of the investment. So, using the previous example, with a Capital Gain of $50,000. Under the proposed changes, $37,500 would be added to the individual’s assessable income.

All investments made prior to 1 January 2020 will not be affected by this proposed change nor will investments owned by Superannuation funds – noting of course that the discount for assets held by super funds is 33% (not 50%).

For the proposed changes to the Capital Gains Tax discount to take effect, Labor would need to win the election and legislation would need to pass through both the lower and upper house of parliament.