For many Australians, owning a negatively geared investment property is almost a rite of passage but, while many consider it a tax effective way to grow their investment wealth and to reduce their personal tax, it may not be the best way forward, said Jonathan Philpot, wealth management partner at HLB Mann Judd Sydney.
“Using gearing to build wealth can be risky and negative gearing into property carries a higher risk without a guarantee of a greater return opportunity.
“A negative gearing strategy can pay off if the value of the property appreciates enough over time to deliver a strong capital gain but this isn’t always the outcome. And the capital costs of running and maintaining an investment property can be high.”
Mr Philpot said a lower risk strategy that is often overlooked is simply making extra concessional (before-tax) contributions to superannuation.
Accessibility an issue
“Many are of the view that super is locked away and less accessible when compared with other forms of investment. While it is true that superannuation is locked away until retirement – or at least age 60 for most – property is far from an easily accessible asset.
“Property is an illiquid asset and investors can only access the capital upon the sale of that property. The income generated from rental is generally low – often at around 3 per cent per annum or less – and this income is often being utilised to meet loan repayments.
“For a property investment to achieve its potential it should be at least a 10 year holding, meaning the wealth invested in a property can also be viewed as ‘locked away’.”
He added: “Regardless of how wealth is built over a lifetime, there is no doubt that in retirement the most tax effective place for wealth to be held is within super”.
Long term savings
“Given the restricted concessional contribution limits of $25,000 a year that now apply, people can no longer deposit a large lump sum into super, but rather need the benefit of time to build up their superannuation balances.
“The smart strategy is to begin this from the age of 40, with the aim of building a super fund up to the $1.6 million balance cap limit,” he said.
So which strategy is best?
Mr Philpot used the example of a 40 year old professional, Sarah, earning an income of $100,000 a year and with a superannuation balance of $100,000.
Assuming Sarah’s super generates an average return of 7 per cent per annum and that her salary grows by 2 per cent a year, her balance through compulsory super alone would increase to $718,683 by the time she is 60.
However Sarah is also in a position to save additional funds for the future and has spare cash flow of $12,500 a year. She considers the option of negatively gearing into property versus making additional annual contributions to super.
If Sarah decides to buy a $500,000 investment property that is 100 per cent geared with the loan secured against her existing home, she would have upfront out-of-pocket expenses of about $20,000 for stamp duty and legal costs.
Sarah could expect to earn rental income of around $15,000 or 3 per cent per annum on the property, less annual expenses of about $5,000, giving her a net income of $10,000 per annum.
Assuming Sarah has an interest-only loan at 4.5 per cent per annum, her interest repayments would be $22,500 a year. Sarah would need to put her $12,500 toward the loan repayments.
Sarah’s taxable income would be reduced by the $12,500 income loss on the property resulting in a personal annual tax saving of $4,763.
Assuming the property’s value would appreciate by an average of 4 per cent per annum it would be worth $1,095,562 in 20 years’ time.
If Sarah sells the property at age 60 (after ceasing work) she will have a capital gain of $556,128. After repaying the principal of the loan and allowing for tax and other expenses, Sarah would have cash available of $482,091. When added to her superannuation balance, of $718,683, her overall investment wealth is $1,200,774.
However only $718,683 of the wealth is held within super and so would be relying on the current contribution rules to still be in place, and it would take her a number of years to contribute all of the $482,091 into super.
Making additional super contributions
Alternatively, Sarah could invest her $12,500 into superannuation by making an additional concessional contribution each year. She could then claim a personal superannuation deduction which would also result in a personal annual tax saving of $4,763.
The $20,000 that she would have spent in upfront property costs could also be contributed to her superannuation. By age 60 Sarah’s superannuation balance would be $1,209,011.
“Sarah’s financial position in 20 years’ time would be similar under each option, however under the second scenario it is all already within the super environment. Furthermore, she would have taken a lot more investment risk using a negatively geared property and probably not received enough of a return premium to warrant that risk.
“It is also unlikely that Sarah would have an interest-only loan for the entire 20 year period as banks tend to limit the duration of the interest-only period. At this point Sarah would need to begin repaying principal plus interest and therefore increase her out of pocket portion of the loan payments. This could mean increased repayments of about $11,000 a year.
“Over a 20 year period it’s also likely that the investment property would need major repairs and maintenance work, which hasn’t been factored into the above calculations. There is also the risk of future tax changes, particularly with Labor’s proposed increase to capital gains tax and negative gearing.
“Clearly, making additional contributions to super would be the less risky strategy and over time would increase Sarah’s superannuation savings by $490,000. It would also mean that all of Sarah’s investment wealth would already be in the tax effective superannuation environment by age 60,” Mr Philpot says.