Calculating return of investment, watch out for tax.

One thing I notice a lot of investors do when calculating their return, is the only “add up a total figure in the end”, without taking into consideration of the time when the profit comes in.

An example is those who buy negatively geared properties in hope of big capital gain, they seem to not realize all of their profit comes in a single gigantic swoope when they sell (that is assuming if they do sell for big profit) right at the end. Until then, they are losing money constantly. One of the biggest problems I notice with people who do calculation like that is, they fail to take into consideration the amount of tax they need to pay as the result of that.

Let’s use an example:

Peter and John are both holding their properties for 10 years and sell at 11th Year.

Peter buys 5 x 300K properties, make a positive income of 30k per year, and then sells his entire portfolio during 11th year for another 200K profit. So Peter’s profit is 30 x 10 + 200 = 500K

John buys a single property at 1.5 million, he loses $5000 each year, and then sells this house during 11th year for 550K profit.

On the surface, it would appear as though John is breaking even with peter, because (-5000 x 10) + 550,000 = 500K as well.

However, there is one factor that can break the game, that is tax.

Because Peter’s income is split relatively evening throughout the 10 years, this means each year, Peter would only have 30K additional taxable income on top of his usual income, and the profit of 200K during 11th year isn’t going to be taxed too harshly.

Whereas John makes no profit until the very end. This means John is bleeding $5000 each year and then gets taxed at $550k on top of his income during that single financial year alone, and that is a heck lot of tax to be paid and is likely to result in John’s actual profit ends up lower than Peter’s despite John’s property has a much bigger capital tax gain.