Tag Archives: Stamp Duty

Investing, Renting

Gearing: understanding the buzzword

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Gearing relates to how you structure the financial position on an investment property (or any income producing asset). You can be positively, neutral or negatively geared.

I have a friend who has some big ideas on property, some of which are great and others I question whether he is regurgitating buzzwords without necessarily understanding what they mean. My friend wants to buy an investment property and negatively gear it, but what he hasn’t considered is that negative gearing requires a cash outflow on his part, and when he isn’t in a surplus cash position to start with this could be a financial burden. “Negative Gearing” is a big tax buzzword but for most normal people it can live up to it’s name and just be… negative.

Negative Gearing

Negative gearing is where expenses outweigh income. For example, you own an apartment with a mortgage that you rent out. Typical expenses would be, for example:

$    1,200 / mth mortgage payments (assume interest only)

$     800 / qtr strata fees

$    1,000 / yr council rates and water bills

$     500 / yr occasional repairs and maintenance

$     300 / yr rental agency fees

$19,400 annual expenses

You receive rent of $350 per week, which is $18,200 of annual income. Therefore the property costs you a loss of $1,200 per year. This means you have to spend $1,200 of your own cash each year on this property.

There are two main reasons why people chose to negatively gear:

  1. They are high-income earners who are looking for a tax deduction. The cash outlay of $1,200 will be used to offset against their income to lower their tax obligations. For the highest earning tax bracket this means they will receive a credit against their tax of $588 but the net effect is they still need to outlay $612 cash against the property. Great for someone who has lots of cash.
  1. They are hoping that the capital gain on the property will outweigh the costs of negatively gearing it. For instance, the apartment cost you $380k to buy and if you sell in three years time for $430k, less stamp duty, selling agency fees etc you have made a gain of approx $20k, of which you can keep just over half after paying your tax bill, which means for $1,836 cash outlay, you have made a net gain of $8,164 (which is not a great return, but that’s for another post!).

All good reasons to negatively gear, but if you don’t have surplus cash, are not on a high tax rate and/or expect some capital growth in the property regardless, negative gearing might not be for you.

Neutral Gearing

This is where you manage the expenses and income of the property to effectively net out to zero.

I have chosen this option in the past because I wanted my investment property to just “pay for itself” while it grew in value.

Positive Gearing

This is where you want to earn an income from your property. Great if you don’t earn a salary, i.e. you’re a non-working parent, or you are retired and are living off your assets.

This is where the rental income on the property is greater than the expenses. You may pay tax on the net income earned (depending on your overall tax position), but you will be receiving income and therefore a cash inflow.

Before I went on maternity leave I prepaid a year of mortgage repayments on the investment loan on my mortgage to bring forward greater expenses in the year I was still earning a wage (i.e. the property was negatively geared in that year). The year I wasn’t earning an income while on maternity leave my property was positively geared, which provided a small but helpful income. So you can change your gearing depending on your situation.

So please don’t get caught up in buzzwords like “negative gearing” without fully understanding what they mean to you. If anyone has any other buzzwords they would like clarification on, please include in the comments below…

Financing

#4 How much cash and/or liquid assets do I currently have?

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When we’re thinking of buying a property sometimes we can focus on just the amount required for the deposit. But there is a lot more to paying for a property than that.

What is “cash”?

  • The money you have in your wallet, which isn’t going to get you far when buying a property so you can exclude this (!),
  • The net CREDIT balance in all of your bank accounts. For instance you may have a transaction account, which your salary gets paid into, you pay bills from, have an ATM card and draw cash out of. You may also have a savings account, and
  • The balance in a term deposit that is not locked in for a fixed period of time, i.e. a high interest earning account such as an ING account or similar.

What are “liquid assets”. In this case liquidity has nothing to do with a state of matter such as water, but instead refers to how easily an asset is converted to cash.

  • The simplest example is shares, which are traded on a stock exchange and can be sold for cash as quickly as you can call your broker, and
  • A term deposit locked in for a fixed period of time that is either maturing soon or the contract can be broken early for a penalty fee.

So go ahead and add up all of the cash and liquid assets you have and then let me tell you how that hard earned money will be spent when you buy a property…

1. Firstly you need a deposit. Nowadays financial providers will tend to lend you up to an 80% LVR, but sometimes 90% if you take out Mortgage Insurance (MI) and/or have a guarantor. But beware, MI is very expensive.

I would like to quickly explain how MI works. Going back to our $500,000 property, if you only have a $50,000 deposit your mortgage provider can charge you insurance in the event you default on your repayments. On a mortgage of $450,000 you could pay around $8,820 of insurance (about 2% of the loan).

You can either pay the MI upfront (which means you need $58,820) or add it into your mortgage, which may seem like a good idea as the additional monthly payments aren’t that much (for e.g. $67/month) but you end up paying interest on the MI and over the life of a 30 year mortgage you could pay almost three times the amount of insurance!

2. Next we have lots of purchasing costs that can really add up: lawyers or conveyancers fees, property search fees, building and pest inspections, mortgage and associated fees etc. I would budget for another $5-10k on top of your deposit, and more so if you do this for a number of properties you try to buy along the way.

3. Then comes the big hitter, Stamp Duty. Stamp Duty is charged on the value of the property by the state government for transferring the property from one owner to another. Stamp Duty varies from state to state, generally increases in proportion with the value of the property and concessions may be given for first homeowners. Using our example of the $500,000 property and lets say we’re in NSW, the stamp duty would be almost $18,000, or 3.6%.

4. And then finally, after the deposit, stamp duty and purchasing costs, do you have any more money left over? What you can do with this will be discussed in later posts.

In summary, to buy a $500,000 property, we need to have $128,000:                                                                               $100,000       20% deposit                                                                     $  10,000        purchasing costs                                                           $  18,000        stamp duty                                                           $128,000

 

If I had $100,000 and thought to myself, “well I’m ready to go, that’s my 20% deposit for a $500,000 property”, in actual fact I can only afford to buy a $400,000 property:                                   $  80,000        20% deposit                                                                     $   7,000        purchasing costs (assuming we economise)           $ 13,500        stamp duty                                                          $100,500

 

This analysis tells us what value property we can buy, but it does not tell us what value property we can afford to pay mortgage repayments on.

Coming soon… 2. What mortgage payments can I comfortably afford?