You would be excused for thinking that negative gearing has been totally abolished in the Federal Government’s Budget.
In a sense that perception is understandable given that more than 90% of all current negative gearing tax claims are made on investment properties.
And for investment properties other than new builds bought after the Budget these losses will now be quarantined to the property and not allowed to be applied against other taxable income such as salary.
With the vast bulk of existing negative gearing claims now coming from about a million investment property landlords, that change will over time eliminate most traditional investment negative gearing claims with new builds the only notable exception.
However, negative gearing has not been outlawed on other asset classes so there is still potential to borrow and due to interest and other costs that exceed income from the asset, to claim a negative gearing loss against other income.
Negative Gearing Opportunities Remain
Perhaps the most obvious remaining negative gearing opportunity apart from new builds is commercial property.
Commercial property such as warehouses, shops and self-storage facilities are also readily rented to businesses using leases and thus provide rental income just like a residential property.
In some ways, depending on their location and business purpose, commercial properties may be more resistant to unexpected tenant departures than residential properties, although business failures are always a possibility should the economy turn sour.
This asset class shares very similar characteristics to a residential investment property—banks will often lend a high percentage of the purchase price which helps to plump up the interest cost and opportunity for a negative gearing claim.
Capital Gains Add the ‘Fizz’
Like all property purchases, the concept is that the value of the property is rising strongly even though you are making a cash-flow loss in the early years of the loan.
Without the “fizz” of future capital gains to compensate for these years of negative cash flow, the whole point of the exercise is lost, with or without some tax refunds along the way.
In that respect the quality and prospects of the commercial property really matter, as does the treatment of the eventual capital gain, which will be subject to the at times less generous inflation indexing method rather than the previous 50% CGT discount which applied after owning the asset for a year.
Like all investments, the quality of the asset is of the greatest importance and tax concerns should come a distant second, although that rarely happens.
Buying REITs an Option
Another option for negative gearing through property is to use borrowed funds to buy shares in Australian real estate investment trusts (REITs).
This has a number of advantages over buying a single commercial property.
There is much more diversification across assets and also locations and you can also start much smaller than biting off the huge chunk of a commercial property.
Further diversification is available through exchange traded funds such as Vanguard’s Australian Property Securities Index (ASX: VAP) which buys a suite of listed REITs in proportion to their market capitalisation.
In that way it is similar to a classic index fund across the ASX 200 index, although in this case it is applying to all Australian REITs in the ASX 300 A-REIT index in proportion to their size.
Another benefit is that all of the property owned through the REITs is professionally managed and there is no need for extra costs such as landlord insurance and you never have to get involved in issues such as rent collection or unplanned vacancies.
Some Pitfalls with Listed Shares
There are two big pitfalls for this approach, however, compared to the popular but now extinguished opportunity to buy and rent out an established investment property.
The first is that the percentage of the asset that you will be able to borrow against the purchase cost will be lower than for an investment property and the margin loan interest rate is likely to be higher.
In the case of the as Vanguard VAP mentioned earlier, the maximum loan to valuation ratio (LVR) allowed by CommSec is 75%.
In practical terms, though, it will be lower than that because of another disadvantage of negatively gearing shares compared to property.
Shares are inherently more volatile than property valuations and because a margin loan is used to buy them and the price might move quickly and without warning, a person with a margin loan needs to keep a substantial gap between their maximum allowed LVR and their actual borrowings.
Either that or they need to keep a substantial amount of cash on the sidelines to deposit quickly to avoid a margin call and the sale of the shares by the margin lender should the value of the shares fall.
Margin Calls Part of the Game
As anyone who has used a margin loan will tell you, negative share market movements can be quite substantial and can come without warning and the time to correct the loss of value is short, so leaving some considerable head room between the actual portfolio LVR and the maximum LVR can greatly increase the ability to sleep well during times of market turmoil.
Despite these disadvantages which can reduce the tax efficiency of negative gearing through a margin loan, it does come with one great advantage—the ability to pre-pay interest for the coming financial year and then claim that amount in the previous financial year’s tax return.
In other words, you can pre-pay the whole coming financial year’s interest in June and lodge a tax return a couple of months later which includes the prepayment as an interest cost.
Of course, other shares can also be used with the same margin loan negative gearing approach with a very similar list of advantages and disadvantages as listed above.
So, for those on the top tax rate who are dismayed that the negative gearing opportunity has been taken away—don’t despair, there are a number of remaining negative gearing opportunities that might work for you.