Paul Clitheroe warns against negative gearing for just the tax deductions
Many Australians are comfortable with using debt to fund investments like a rental property, but financial commentator Paul Clitheroe says they shouldn’t let the prospect of negative gearing draw them into an investment that doesn’t stand on its own merits.
"Tax benefits should be seen as icing on the cake, but a tax deduction alone is not a good enough reason to invest," the veteran investment adviser suggests.
Clitheroe says it’s the sort of debt he calls ‘effective debt’ as it can be a useful tool for building personal wealth.
He says the problem is that many people become irrationally excited about the tax savings of negative gearing.
"Let’s be quite clear on this – a loss on an investment may reduce your tax, but it is still a loss, and the whole point of investing is to make money and build wealth.
"Yet I often hear people justify a dud investment with the claim 'but it's a tax deduction'."
Clitheroe says the bottom line is that tax breaks should never be the main motivation to invest.
"If an asset is only generating a return of 4% and you’re paying 6% interest on the underlying loan, the investment is not building your wealth.
"Over time it will do little more than deplete your wealth unless it is also providing decent capital growth over time."
The ipac executive says an additional pitfall of gearing was assuming the investment will generate sufficient income to meet the loan repayments.
"This can be a dangerous assumption because it doesn’t always happen as rental properties inevitably experience periods of vacancy, and the cash flow that may have made a significant contribution to the loan repayments can quickly diminish or dry up altogether."
On his blog, Clitheroe details how gearing means borrowing to invest.
"Used wisely, gearing can beef up your investment returns and allow investors to purchase high value assets they wouldn’t otherwise be able to afford, like a rental property.
"An investment is said to be ‘negatively geared’ when the costs of owning the asset, including interest on the loan used to buy it, outweigh the returns it generates.
"For example if a rental property delivers annual rent worth $20,000, but its running expenses including mortgage interest come to $30,000 each year, it is negatively geared to the tune of $10,000 annually.
"This figure, which represents a loss, can usually be claimed on tax, and this is where the appeal of negative gearing lies.
"The problem is that many people become irrationally excited about the tax savings of negative gearing."
ipac is one of Australia’s largest financial advisory firms with more than 200 staff, and offices around Australia. It is a wholly owned subsidiary of the AMP group.