CAPITAL GROWTH and the type of gearing heavily impact the overall profitability of your property purchases. And so this article will explain how they can significantly affect your bottom line.
Take a Look at a Common Scenario
You have a rental property worth $400,000 and annually. You pay $24,000 in interest on the loan you took out to buy it, together with other costs totalling $3,000.
While, the rent you receive is $18,000.
This means that you are losing $9,000 in cash — each and every year (excluding tax refunds and depreciation claims, which certainly improves the outcome).
In this very simple example, ignoring the effect of compounding, if the property price does not rise by more than $90,000 over a 10-year period — is this debt a “good debt”?
In this example, the answer is: “No”.
However, history shows us that prices will generally rise with inflation and population growth-driven demand.
And, in all likelihood, the property’s value will grow by significantly more than $90,000, combined with tax deductions for loss and depreciation.
Therefore we can actually class this debt as “good debt”.
Understanding negative, neutral and positive gearing is equally important when making any property purchases. Let us run through these three concepts in a brief example.
Negative Gearing
Using the simplified example above, the $9,000 you are losing each year is called negative gearing, which can reduce the tax you have to pay.
Here is how negative gearing works:
($9,000) Loss
.$3,060 .Income tax refund at 34%
———–
($5,940) .Loss
In this example, we have used a tax rate of 34%. The potential income tax refund rises to $4,185 for a taxpayer in the top tax bracket for 2013, reducing your annual loss even further to $4,815.
Neutral Gearing
Repeating the same example, let us assume the expenses are lower at $20,000 and the rent received is higher at $20,000.
This is called neutral gearing and here is how it works:
$0 Loss/gain
$0 Income tax refund/bill at 34%
———–
$0 Loss/gain
In this example, it does not matter what tax bracket you are in, because there is no loss and no gain from the transaction. So there is no refund or tax payable.
Positive Gearing
Now let us assume the rent is $22,000 and the expenses are still $20,000. This is called positive gearing.
.$2,000 Gain
($680) .Income tax bill at 34%
———–
.$1,320 Gain
In this example, we are also using a tax rate of 34%. The potential income tax bill rises to $930 for a taxpayer in the top tax bracket for 2013. This reduces your annual gain even further, to $1,070.
BOTTOM LINE: When deciding to purchase a Commercial property, you must consider the real holding costs verses the expected capital growth.
If you don’t do that, you can very quickly turn a perceived good debt into genuine bad debt!
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