Reducing the risks of borrowing to buy an investment property
Despite increasing concern about the possibility of a sharp fall in property prices, especially for apartments, investor demand for properties continues to increase, with bank lending to investors reaching record highs.
This demand for geared properties is largely driven by tax considerations following the steep reduction in the tax savings from superannuation, particularly for higher-income earners.
For taxpayers with annual incomes above $250, the maximum tax saving from deductible super contributions will soon be 17 per cent, with the maximum annual deductible amount reduced to $25,000 from July 1. Compared with this strictly controlled regime, which also deprives access to the assets involved until at least age 60, the tax assistance for geared investments is currently unlimited with all losses tax deductible at full marginal rates.
Current investor demand is also being increased by concern that the assistance to geared investors is too generous to last and the desire to take advantage of the current rules while they last. Given the large number of negatively geared investors, almost certainly, as with the 1985 capital gains tax, future rule changes will apply only to new investors.
These considerations increase the attractions of borrowing now to purchase assets to be held for a long time. The emphasis in doing so is to select assets likely to increase in value and generate long-term capital gains. While the running yield is also relevant, having income subject to capital gains tax has two large benefits.
First, the capital gains tax is payable only when the asset is sold, and transfer of assets by bequest doesn't trigger a liability until the beneficiary sells the asset. Second, the capital gains tax rate is half the normal marginal income tax rate once the asset is owned for longer than 12 months.
Selecting the asset to be purchased is the key to a profitable outcome and careful research and evaluation of prospects is crucial. The emphasis should be on the merits of the assets purchased and not the tax savings from the transaction. Negative gearing losses will be generated from both poorly and wisely chosen investments.
Also, while the tax benefits of gearing are increased by not paying off the investment debt, investment risks can be reduced by other strategies. These include concentrating on paying off any non-deductible debt on a family home and building up assets owned by a partner with a lower marginal tax rate.
For older people able to access their super within a reasonable time, non-concessional super contributions are a tax-effective alternative to paying off an investment debt. These strategies all have the advantage of maximising the gearing tax deduction while reducing the final outstanding debt and overall risks.