Negative Gearing: A Basic Guide to Profiting from a Second Home and Saving on Tax

The prices of houses, in the long term, always seem to go up, which is why many investors find the housing market to be so promising. For those interested in making the most out of an investment property, below is a series of tax considerations to keep in mind.

What Is Negative Gearing, and Why Should You Do It?

Over the last couple of decades in Australia, a tax-saving strategy called 'negative gearing' has been extremely popular. The idea is to purchase a second home and then rent it out, taking out a loan on the property such that the deductible interest causes the expenses to be greater than the income. Rental property losses are allowed to decrease your income for tax purposes, so essentially, by buying a second home, you are not only investing in the property market, reasonably expecting that the property can eventually be sold for much more than you bought it for, but you can substantially increase your annual tax refund.

What About Capital Gains Tax?

Negative gearing has been controversial. The tax benefit second home buyers receive has been accused of providing an unfair tax advantage to those who can afford such investments. And it's completely true - for those with the available equity, the tax breaks make it an unusually enticing scheme. The main drawback of the scheme is the capital gains tax that will eventually payable on the sale of the asset. In Australia, you are expected to pay tax on 50% of the profits from any investments held for more than 12 months, and 100% of the profits on those held for less than 12 months. Investments included under the scheme shares, currency trading, some miscellaneous valuables, and, of course, real estate.

How Can I Avoid Capital Gains Tax?

There is one frequently used scheme to get out of paying the capital gains tax. The law says that if you sell a home that is considered to be your principal place of residence, then you do not have to pay capital gains tax on it. The law seems intended to prevent single homeowners from paying tax on the sale of their home, but it can be used when you have a second property as well. The trick is to live in the investment property first, then rent it out. If it has been rented for less than six years, you can claim the 'temporary absence rule', which disqualifies you from having to pay capital gains tax. For those who have generated a substantial profit from the sale of their property, this could be a substantial coup.

Is It a Good Investment?

There is some risk in exploiting the principal place of residence scheme. Because of the six-year rule, if there is a temporary slump in the housing market, the buyer has to sell the home regardless, unless they want to pay the capital gains tax or are willing to move back into it. However, it's worth noting that similar risks are associated with other investments such as shares, for example, where companies can suddenly go bust. Shares, though, do not come without the added tax imperative of real estate investments (in fact, stockholders pay additional tax on dividends received). For this reason, as well as the other reasons discussed above, investing in property should be given serious thought by investors looking to multiply their savings, like with International Professional Services Pty Ltd.