Investors can usually offset the loss from negative gearing against other income for tax purposes. It creates a tax benefit, in the form of less tax being paid than otherwise, and this tax benefit in a sense adds to the investment return on the asset.
Negative gearing only makes sense if the investor expects to earn an eventual capital gain more significant than the losses incurred while holding the asset, such that overall the investor is better off by investing. Bear in mind that capital gains are usually taxable, although there is often a 50% discount which can be had.
When most people think of negative gearing, they think of residential property investment. But in reality, negative gearing can apply to any investment asset. The key to remember is that the long-term prospects for the investment must be right, such that the investment makes a significant profit overall. ‘
The following example shows you one way that negative gearing can be applied in the share market.
Agnetha owns a hairdressing salon which earns her about $100,000 a year after expenses. Her marginal tax rate is 37%. Agnetha owns one home, valued at $600,000. She has a debt of $200,000 in this home, meaning she has $400,000 in equity. Here is how her assets look:
Agnetha decides to make some share market investments. She comes to see us, and we discuss the benefits of dollar cost averaging into an index fund. (We won’t go into the details of that here). Agnetha decides that she will establish a line of credit loan against her home to the value of $200,000. She will use this to make a series of monthly purchases of units in an index-tracking Exchange Traded Fund (ETF). At the end of two years, she has purchased $200,000 worth of units (including brokerage). Her net assets now look like this:
|Units in ETF:||$200,000|
Her preferred ETF pays a distribution that is equal to 4% per year. It equates to $8,000 per year on the holding. The interest rate is 6%. It equates to $12,000 in interest payable. Agnetha, therefore, makes a ‘loss’ of $4,000.
Agnetha’s marginal tax rate is 37%. Her income tax reduces by $1,480 as a result of the $4,000 loss (37% of $4,000 is $1,480). The after-tax loss on the investment is now $2,520. It is a 1.26% of the amount she has borrowed – meaning that if her investment rises by more than this, the capital gain will more than offset the short-term loss. However, the capital gain is taxable, at a discounted rate if Agnetha holds the investment for more than 12 months. For Agnetha to make a profit after CGT, the capital gain needs to be 1.55% per year.
It is lower than the current inflation rate, meaning that Agnetha will make a profit if her investment (bought over an extended period) keeps track with inflation.