Negative gearing is one of few remaining pieces in Australian tax law which can still benefit the taxpayer. It also has implications on how much money you can borrow from the bank as banks consider negative gearing when deciding how much to lend you. This post aims to explain what negative gearing is in a nutshell and how it impacts your borrowing power.
How does negative gearing work?
In Australian tax law, if you are a fulltime employee earning an income, you need to pay tax on that income. How much tax you pay depends on how much money you made and Australia employs a marginal tax rate which means that the percentage of your income tax will also change as your pay increases.
Under normal circumstances, expenses you incurred in the course of earning your income can be excluded from the income you pay tax on. As an example, if you made $50,000 however had to buy your own uniforms, work phone etc. which ended up costing you $2,000 – you are only required to pay tax in $48,000.
Generally, you can only exclude your work related expenses from your income however negative gearing is one of the few exceptions to that rule. This means that if you have an income producing asset where expenses for that asset are higher than the income it producing, the government allows you to deduct that loss from your overall income with property being the most common example. To share an example, let’s suppose you own a house that produced $10,000 in rental income however you paid $8,000 interest every year, $2,000 in rates, 1,000 in insurance and $2,000 in general repairs. In the end, you paid $13,000 for an income of $10,000 and so were at a loss for $3,000 in the tax year. The Tax office allows you to deduct this loss from your overall income so if you made $48,000 through your employment, you can take off the $3,000 loss from the property and only pay tax on $45,000. In essence, you utilised negative gearing to reduce your overall tax.
How does negative gearing impact my borrowing power?
When banks workout your overall borrowing power, they consider any income you made from your property and deduct any expenses associated with that property to work out your ‘disposable income’ – see my post How do banks work out your borrowing power (Servicing position)? for more information.
However, Banks also know that if your property expenses are greater than the income, the Government allows negative gearing and so they calculate this when considering your loan and add back the tax savings pretty much as income so it better reflects your current position and enables you to borrow a little bit more.