"Understanding negative gearing and positive cash flow"

Hi Followers

Thought I'd share this article , a must read for investors!

Negative gearing is running a property at a loss so that the overall effect of the property on your tax return is a deduction. The tax saving that results can help support the property. If the tax saving is good enough it may even result in the property having a positive cash flow.

For example:

Notice how the property is only cash flow positive if the owner is in the 46.5 per cent tax bracket which, from July 1 2009, means he or she would have to earn more than $180,000 a year.

The more likely tax bracket would be 31.5 per cent. To be in this bracket from July 1, 2009 you would have to earn less than $80,000 a year and more than $34,000. Note, this lower threshold increases over the next few years but the upper threshold is expected to stay the same until 2014.

Buying a property and having $45 a year extra as a result sounds good, doesn't it? Even if you're only in the 31.5 per cent bracket and only have to top the property up to the tune of $1905 per year it's not bad.

So now all you need to do is rush out, buy this property, sit back and wait for it to pay itself off. But let's look at what sort of property would fit the above example.

The special building write-off is quite high. This could be because it was built between July 18, 1985 and September 16, 1987 so it qualifies for a depreciation rate of 4 per cent. But even at this rate it would have to have cost $150,000 to build way back then. Also, if this is the case the property is only entitled to depreciation over 25 years so this claim is about to expire. It's more likely that the 2.5 per cent rate applied, which means the building write-off will last for 40 years after it was constructed (100/2.5).

To qualify for $6000 in building depreciation a year at the 2.5 per cent rate the building must have cost $240,000 to build. Yet the interest of $22,000 in the example could only cover borrowings of $258,823, assuming an 8.5 per cent interest rate.

A substantial deposit would have been necessary to have such a low interest expense and still receive such a high rate of rental return. You see, at a standard rent return on investment of 5 per cent the property would have to be worth $400,000 to receive $20,000 in rent.

Maybe this could have been achieved by buying well and some clever renovations, but if it was achieved because of a large deposit then the $45 per year return is a poor yield on those funds unless there's capital growth.

The key factors to look for in a positive cash flow property are a strong rental return compared with purchase price and a low land value, as land isn't included in the special building depreciation amount. Generally these qualities are found in remote areas where capital growth isn't as good.

A more likely profile is a $300,000 property where $310,000 is borrowed to cover the purchase and associated costs.

{BREAK}
For example:


If the above is typical of properties that are available then it's going to take some real bargain hunting to find a positive cash flow property.

Higher cash flow costs won't improve your cash flow. In fact, if they're not deductible, such as initial repairs, they work against your cash flow.

The two factors that increase your cash flow are higher depreciation (including special building write-off) and a high tax bracket. Higher depreciation as a percentage of the purchase price is achieved by buying a newish property with a low land value, such as a unit or in a remote area, because the special building write-off is based on the original cost to build the property.

Even if you find a property that has a positive cash flow you still want to achieve some capital gains to offset the CGT. CGT will be payable even if you sell for only enough to cover the original purchase price plus buying and selling costs. This is because you're required to reduce your cost base by the amount of building write-off you have claimed.

If you can't find a positive cash flow property you need to make sufficient capital gains to cover the tax on the reduction in your cost base, the cash shortfall each year you own it and the CGT.

(The mystery of how this is calculated was detailed in a two-part report in the January and February 2007 editions of API.)

The first example in this article would require capital growth of 1 per cent per annum (assuming a $400,000 purchase price and large deposit) to break even, but that doesn't take into account the loss of opportunity with the money used for the deposit.

In the second example you'd need capital growth of 4.4 per cent per annum just to break even. This is based on holding the property for five years and assuming you're in the maximum tax bracket both during the time you owned it and when you sell it.

If all else remains the same but you're only in the 31.5 per cent tax bracket during the period of ownership and when you sell then the first example requires capital growth of 1.4 per cent per annum to break even. The second example requires 5.2 per cent per annum.



As discussed, properties that lend themselves to positive cash flow tend to be in areas of low capital growth. Assume nothing and always crunch the numbers so you know exactly what you're asking the property to achieve.

This information was gathered from:
http://apimagazine.com.au/api-online/property-investment-articles/understanding-negative-gearing-and-positive-cash-flow

DEB BRADY
0405 570 903