- by Chan & Naylor
What happens if you get a positive cash flow investment and you’re a high-income earner and vice versa, and what positive gearing strategies can you employ?
Sarah Megginson, editor of Your Investment Property magazine, invited Ed Chan, Chan & Naylor’s co-founder and non-executive chairman, on YIP Talk to share his thoughts on positive cash flow investments and positive gearing.
YIP is one of the leading resources for relevant information on cash flow, rental demand, and long-term capital growth for property investors.
Listen on SoundCloud or check out the transcript of the interview below.
Positive Cash Flow Investment
Sarah: When you talk about a positive cashflow investment, it’s the rent, is going to more than cover your expenses.
Sarah: So you’re going to have an extra amount of money in your bank each week or each month.
Sarah: And is that income, do you have to pay tax on that or how does that work, in terms of your tax?
Ed: Yes, you do have to pay tax on that, and the tax rate that you pay is based on your personal tax rate. So if you’re on a 20% tax rate, then you’ll pay 20%. And if you’re on a 47% tax rate, you’ll pay 47%.
Sarah: Okay, and so that starts to explain how positive cashflow investing can help or hinder different types of investors. So based on your tax rates, what would you say a positive gearing strategy, what kind of investor would that suit and what kind of investor is that possibly not as suitable for?
Ed: Well, anybody that wants to make money, it’s always best for it to be positively geared. But unfortunately, in real estate and especially around the cities, and the big cities, it’s mostly negatively geared so the rents won’t cover the outgoings and it won’t be sufficient to cover the interest rate.
Now we’ve been very lucky because the interest rates have been coming down, and the further it comes down, the closer you are towards being neutrally geared or positively geared.
But unfortunately, in the main, if you’ve got a big debt on the property, most of the properties are negatively geared, which means that the outgoings, including the interest, is more than the rent.
Sarah: And so that’s another point I was going to ask. What are some of the expenses you can claim for your property investment that are going to help offset, or that are going to be taken out of the rent?
Expenses You Can Claim for Your Investment Property
Ed: Okay, so all the costs and expenses to do with the property itself. So whether it’s water rates, council rates, repairs, and there’s a difference between repairs and capital. Meaning, that if you repair something, put it back to its original condition, then it’s a repair, and you can claim that completely. So the whole lot at once.
But if it’s improving the item, so if you put in a new kitchen for example, then you can only depreciate that, but you can still … Depreciate means you can still claim the item, but it’s over a longer period of time.
Sarah: That’s a really good point. The difference between a repair and replacement. So just for an example, if you were in a kitchen and you had a broken cupboard, and you replaced that one cupboard, that would be a repair, is that correct?
Ed: Correct. As long as you put it back to its original condition, then that’s a repair.
Sarah: But as soon as you improve it?
Sarah: That’s now-
Ed: An improvement. A capital item
Sarah: Okay. And so how do investors treat that on terms of doing their tax? It’s quite straightforward to pay for something and have the receipt and claim it, but if it’s a capital item, how would an investor go about working out how to claim that?
Ed:Again, if you get it installed, you will have a receipt from the supplier, and you can then take that receipt and use that as your evidence of having incurred the costs, and the determination as to whether it’s a repair or a capital item would just be based on what we said: Is it replacing the item or is it repairing it to its original condition?
But if it’s improving it, and even fencing, for example, often people pull down the whole fence and they might replace a timber fence with maybe a steel fence, or a brick fence, or a stone fence. Well, if they replace it with a stone fence, they can only depreciate that over a period of time.
Sarah: Right. So if they had just replaced the broken palings, that’s an immediate deduction.
Ed: Correct, yes.
Sarah: Okay. Very interesting. So is there anything else about positive cash flow investments that people should know or consider before they get into this type of investment?
Ed: It’s always best, obviously, for it to be positively geared, meaning that the rent is more than the outgoings. So that you’re not having to supplement it with other income, and generally, most people supplement it with their wages.
However, most positively geared properties, not in all instances, but a lot of positively geared don’t show the same capital growth as negatively geared properties. And the reason for that is simple.
Ed: The reason why a particular property is negatively geared is because the capital value of it is quite high and is proportion to your income. The reason why it’s quite high is because the demand for that property pushes the value of the property up so that the return, which is the rent return.
How to Calculate Rental Yield
The way you calculate rent return is you take your rent, or rent for the whole year, and you divide it by the capital value to work out whether it’s a two per cent return or a five per cent return. It goes down because the capital value has gone up, and that’s because of the demand.
Ed: And if there’s a greater demand, then it pushes the value up, and it’s a seesawing effect because you get a lot of people that come in, they buy, they push the value up because it’s in high demand. It gets to a value where it’s no longer feasible in terms of commercial investment.
So then, the market slows down, and as the supply of the properties run out and the demand continues to increase because our population is growing, and it’s getting bigger, and then the demand becomes bigger than the supply, and the cycle moves forward again. And that happens every so many years.
Sarah: Yes, we’re in a very interesting stage of that cycle now.
Sarah: Excellent. Okay, great. I think we’ve covered everything there. So I guess if someone is interested in getting a positive cash flow investment, particularly I think if you’re a high-income earner and you’re paying 47% tax, then you have to be aware that whatever positive profit you generate, you’re going to be paying 40% or 47% tax on that.
Sarah: So this is a strategy that you really should put some strategy behind and maybe speak to an accountant or a financial planner, and make sure you’re maximizing your tax.
We’ve heard some people say, “That if you’re going to have a positive property, you maybe balance it with a negative one so that you’re going to have a growth on one cashflow, and the other and they balance each other out.”
Fund Negative Gearing Property with Positive Gearing Property
Ed: Yes, there are lots of strategies around that and a lot of commercial properties are hugely positively geared, but a lot of them don’t have the capital growth that well placed, well-positioned residential properties do.
So often, you could supplement a commercial property with a negatively geared residential property, so you get the capital growth, but you’ve got the positively geared from the commercial property to fund the negative gearing on the residential property. And that’s a good strategy.
Ed: However, let me just say that commercial properties are a little bit risky. Unlike a residential property where if you lose a tenant, you might be without a tenant for maximum a month or two.
But in a commercial property, if you lose a tenant, you could be out of a tenant for a year or two years. So it’s significantly riskier. And imagine if you had a loan and you couldn’t fund that loan, or you were relying on a rent to fund the loan, the interest on the loan, but the tenant leaves and you can’t replace that tenant for two years. That’s quite risky.
Ed: So you’ve got to be very careful. For the average person who doesn’t have a lot of extra cash to call on, to be careful of commercial properties. But if you find a really good commercial property, they’re a really good thing.
But just be aware, only a small portion of them have capital growth, as well. The vast, a lot of them don’t have the same capital growth that you get from a residential property.
About Chan & Naylor
Chan & Naylor is Australia’s leading national property, business tax accounting and wealth advisory group – with national offices in South West Sydney, Sydney, Pymble and Parramatta in New South Wales, Wheelers Hill, Melbourne, Moonee Ponds and Hawthorn in Victoria, Brisbane and Capalaba in Queensland, and East Perth in Western Australia that can assist property investors, small business owners, and entrepreneurs with their tax and accounting needs.
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