Could someone give a quick example of the difference between positive gearing and positive cashflow.
Is one better to go for than the other if you are in a high tax bracket.
Thanks for your help.
DaisyGirl
Sorry can’t really give you an example but negative gearing essentially means that you make a loss. The government allows you to compensate for this loss by deducting it from your taxable income. So if you’re in the highest tax bracket this really means that you save 48.5% of which you’d have otherways paid in tax. Doing it purely for tax purposes only doesn’t make sense. Where it does make sense, however, is where you know there will be at least enough capital growth to compensate for this loss.
Now where it really makes sense is where there’s large capital growth. For example imagine that you have a cashflow shortfall from the investment of 0.5% per an annum, but you were achieving capital growth of 10% you no doubt end up better off. The only problem is that you have to sell off to take advantage of this capital increase. That also means that you’ll pay capital gains tax. You also have to be able to service your loan between the period that you buy and the period that you sell.
All in all I wouldn’t recommend negative gearing unless you either have a large sustainable income or you already have a number of positive geared properties to counter the cost.
—
Jeremy Lunn
MelbourneCashflow is the day to day profitability of the investment. Investments provide a return, but may also suffer costs in order to receive this return. Example: a rented property provides an income in the form of rent, but it has outgoing expenses in the form of rates, management fees, repairs, maintenance, insurance and interest payments on the mortgage. When the income from the rent covers all these outgoing costs, the cashflow is said to be positive, because the net outcome is a profit, not a loss.
A positive geared investment is an investment that provides an increase in wealth after tax has been paid. Positive cashflow is a good start, but it is possible to turn a neutral (or even slightly negative) cashflow investment into a positive geared investment by claiming non-cash deductions.
Remember that the difference between gearing and cashflow is that cashflow is profitability without considering tax deductions, and gearing is profitability taking into account tax deductions. An investment may be one of three types:
1. cashflow positive & positive geared
2. negative or neutral cashflow and positive geared
3. cashflow negative and negative gearedIt is impossible for an investment to be cashflow positive and negative geared, because you cannot claim deductions on a profit. You can choose to claim depreciation which may turn a neutral or slightly positive geared property into a negative geared property, but this will simply defer tax, not save it.
DaisyGirl, If you are referring to Margaret Lomas’ terminology in her books, she refers to positively geared as meaning you make a profit before tax, and you end up having to pay tax on that profit. She uses the term positive cash flow to refer to the situation where you would make a loss before tax, but the effect of depreciation ie non-cash deductions, makes you cash flow positive after tax.
The latter is fine if you are in a high tax bracket for a limited number of properties, so that the depreciation is “nipping away” at your highest marginal tax. As Crashy points out this will defer tax, as you will have to pay correspondingly more capital gains tax when you eventually sell, but as I keep trying to get through to him, you only pay tax on half of your capital gain, and it will be in time eroded dollars if you hold the property long enough. The whole idea of using depreciation is to keep you afloat in the early stages is so that you can have ownership of a few quality properties closer to the capital gain action (although this zone of suitable properties has moved out away from the CBD a bit further in the last three years!)
Jim
Remember that the difference between gearing and cashflow is that cashflow is profitability without considering tax deductions, and gearing is profitability taking into account tax deductionsCrashy, Ireckon you’ve got this the wrong way around.
Whether a property is positive or negatively geared is the situation before any tax deductions related are taken into account. ie if a the income from a property is greater than all the outgoings related to that property (interest, repairs, insurance, rates etc) then the property is positively geared. If it doesn’t then it’s negatively geared.
It is possible to turn a have positive overall cashflow with a negatively geared property if there is sufficient non cash deductions (eg depreciation allowance) which can be offset agains other income (usually from job). The problem is if the other income (job) stops then you lose the tax deductions and the cashflow can become negative again.
Rod.
Good morning,
This may seem like a dumb question, but how do non cash deductions work?
Cheers
DannadsHi Dannads,
Non cash deductions are deductions for expenses which you haven’t had to physically pay for in cash. The main quoted one is the 2.5% building allowance for property built since 1987. This means you can claim 2.5% of the original construction cost of the building each year over a 40year period. eg: if you buy a new $160K property and the value of the building (excluding chattels and land) is $100K you can claim a $2500 tax deduction for 40 years.
If you do a search you’ll find many references on the forum about this – search for posts on quantity surveyors.
Rod.
Rod
“Whether a property is positive or negatively geared is the situation before any tax deductions related are taken into account.”
I get what you are saying, but there is gearing (as in leverage) and then there is gearing (as in after tax profitability). Since tax deductions are a major part of the negative gearing strategy, is it not better to refer to gearing in post tax terms? And since cashflow is the short term profitability, while gearing is the profitability on a yearly scale, why would you omit the tax savings for that year? I thought that is why we had two different terms, cashflow and gearing.
Perhaps other members can debate this issue.
Jim
“but as I keep trying to get through to him, you only pay tax on half of your capital gain, and it will be in time eroded dollars if you hold the property long enough.”
Quite right, thanks for reminding me. But dont forget that many people forgetto allow for the investment return on the saved capital over the same period. Its all swings and roundabouts.
Dear all,
i’ve seen this guy at the Melbourne INvestor Corp at Glen Iris yesterday.. he didn’t try selling me properties, but i find that his property are genrally positive geared bu cashflow neutral or even negative.
But i’ve learnt something interesting. He was telling me that you could claim tax deductions even though your rental income is higher than the cost of managing the property plus interest repayments. This i find interesting and wants to know if any of you knows about this? i don’t quite understand how you could claim a tax deduction when you’ve made a gain? his answer to my queries wasn’t up to expectation, he just say, ‘yes you could, our accountant assure us you could and i’m doing it myself’. I would assume tax deduction is only allows when u’ve made an overall loss?
Anyway, he’s more into buy and hold and waiting for capital gain type of investing, which isn’t really my cup of tea as inflation would rise and your money in capital gain isn’t as much as it’s worth now. i would rather cashflow positive from the start plus any capital gain in the end.
answers anyone?
cheers
kevin
Kevin
It is possible to have slightly positive cashflow but still claim a tax deduction, if you claim depreciation (and building tax, as Rod nicely highlighted). In order for that to happen, it would need to be slightly positive cashflow. While you do get a tax deduction, it wont be very big. Proerties like this should be referred to as neutral cashflow, not positive cashflow. Since the main aim of negative gearing is tax deferment, I wonder if it is really worth the effort to claim deductions on such a property?
Crashy,
that’s precisely what i thought, it doesn’t seems rewarding to engage in such properties. so he’s not wrong to mention that you could do that? ok, now i get it, at least he’s not trying to glaze over the facts
but the properties they’re into are mostly apartments that’s leased out for developer management, that is then rented out. and they’re in the CBD (Melbourne) sounds very risky to get into apartments now anyway.
but i’ll have a look at the figures he’ll be sending me, no harm learning more thru that
cheers,
kevinsounds very dangerous
Ive read some posts here about people getting done over by managed apartments.
sounds very dangerousIve read some posts here about people getting done over by managed apartments.
i went in skeptical, came out the same [8D]
does sounds unconvincing really..
Kev
Kevin, you can claim depreciation allowance for any property, regardless and totally independently of the rent and expenses for the property. It all depends on the value of fittings as per the Q/S report if you get one. Older properties that are more likely to be cash flow positive may have less value in the fittings, but it’s still independent of any rent and other expenses. You will need an income to offset it against to make it worthwhile of course, but this income can be from any sources. It just improves your cash flow in the early years so you can buy more property. I really don’t see what the positivity or negativity of the gearing has got to do with it.
Jim.Jim
I understand from Steves book that he does not claim depreciation (might be wrong). Are you saying he would be wiser to claim it?
Jim
“but as I keep trying to get through to him, you only pay tax on half of your capital gain, and it will be in time eroded dollars if you hold the property long enough.”
Quite right, thanks for reminding me. But dont forget that many people forget to allow for the investment return on the saved capital over the same period. Its all swings and roundabouts.
Crashy, I think you have this all backwards again. The capital saved by depreciation swings in favour of depreciation.
Let’s say I have a depreciation allowance of $10,000 in year 1. This gives me a tax refund of $4850. I’m going to put this refund straight back into a second property that is going to give me a capital gain averaging 7% for the next 25 years, after which it will increase to 1.07^25 * 4850 = $26323. (^ means to the power of) When I sell this property, I’ll have to pay cgt on this of {{26323-4850)*0.485}/2 = $5207. Therefore my net cash in hand owing to the contribution of that tax refund will be $21115.
Now what about the first property? Taking that tax refund back in year 1 will reduce my cost base accordingly, resulting in an increase in the cgt of (4850 * 0.485) / 2 = $1176. Big woop!
Lets just take those numbers back to today’s dollars, ie divide by 1.035^25 = 2.36 assuming an inflation rate of 3.5%. My contribution to the second property will be worth $8934, but my increase in cgt on the first property will be worth $497 in today’s dollars.
Maths of compounding is so fun!
Now for a bit more fun, lets assume we put that tax refund in year 1 into a good cash account that pays 7% pa, ie with no capital gain involved, just to see the effect of nipping away at your return by the tax man. This is the main benefit of capital gain, that you don’t pay tax on it until the end, which allows it to fully compound. (This was the subject of an earlier discussion)
Each year the taxman nips off 48.5% of your income, so effectively it compounds at 3.605% pa. After 25 years, my $4850 will increase by 1.03605^25 to $11756 cash in hand compared to $21115 with capital gain. (The tax has been taken out progressively so there is none at the end cf CG).
To be fair, the capital gain tax “divide by 2” rule saved $5207 in tax, but progressive tax is much worse than tax at the end. Same principle applies to trading stocks and property for that matter; the taxman nips your compounding tree in the bud each time you trade.
It’s all in the exponentiation!:
Yield | 10 Yrs| 25 Yrs| 40 Yrs |
|
|
|
|
3% | 1.3 | 2.1 | 3.3 |
6% | 1.8 | 4.3 | 10.3 |
9% | 2.4 | 8.6 | 31.4 |
12% | 3.1 | 17.0 | 93.1 |
15% | 4.0 | 32.9 | 267.9 |
Jim
Jim
“I’m going to put this refund straight back into a second property that is going to give me a capital gain averaging 7% for the next 25 years”
then
“Now for a bit more fun, lets assume we put that tax refund in year 1 into a good cash account that pays 7% pa, ie with no capital gain involved, just to see the effect of nipping away at your return by the tax man.”
you are comparing apples with oranges.
You are giving the first example a bias. Why cant you invest the saved capital into an asset that DOESNT get nibbled by the taxman? Secondly, why always use 48.5% as the tax rate? The average rate is 31.5%.
Swap the taxable/non taxable investments around and see what happens….
hmmm just read it again.
The argument is not about the compounding effect of the refund/excess cashflow. It is about whether it is better to claim depreciation or not. You are suggesting that only the refund can be invested in another property, when the excess cashflow can also be invested that way. You make it sound as though the refund money is better than the cashflow money because it can be invested differently, which is wrong. Money is money and it can be invested in any way.
Having said that, redo the sums on a level playing field and I will happily eat my hat if I am wrong.
That oranges thing was an aside anyway Crashy, based on an earlier post (you were involved with) about income from dividends etc compared to capital gain.
I use 48.5% because in most of my posts about depreciaiton I say that it’s most effective on just a few properties so that it’s working away at the maximum marginal rate.
The whole “negative to positive based on depreciation thingy” pretty much falls over if you drop below the 43.5% bracket. Well it can be summed up pretty simply by the following:The lower your tax bracket, the further from the cbd you will need to buy before you become cash flow positive.
“Is one better to go for than the other if you are in a high tax bracket.” was the original post.
Give us some real numbers to illustrate your point Crashy. I’m really into numbers if you haven’t noticed. [
]
Regards, JimSorry Crashy, I’m leapfrogging. The cash flow money is not relevant. I’m just looking at time value of money. The depreciation allowance is vital to me buying 4 properties instead of just 1, so in effect it’s being put back into property.
I’m getting the money today, and I can do whatever I please with it, but anything better than inflation has got to be better than just leaving it with the tax man just to make your cgt a little bit smaller in umpteen year’s time.
Jim
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