Why I Wouldn’t Buy an Investment Property to Save Tax

A fight has broken out. Last week I told Mario and Maria that I wouldn’t buy an investment property to save tax. As soon as Mario got back to the building site, he told his brothers, Nick, Con and John what I said. Immediately an argument erupted between he and Nick and they haven’t spoken since. They were best mates up until that point.

Nick left school at age 15 and bought his first house at age 19. He is now 42 and owns 12 investment properties. One of the reasons he loves property is because it helps reduce his tax through a strategy called ‘negative gearing’.

Very simply, negative gearing is where the expenses (including interest) are greater than the rent received from an investment property. E.g. an investment property may have total expenses of $25,000 but only receives rent of $15,000. Therefore it has an annual shortfall of $10,000.

The positive is some of this shortfall is tax deductible.  In Nick’s case, because his marginal rate of tax is 25%, he will get a tax deduction of $2,500. ($10,000 x 25%)

However, he has to fund the remaining $7,500 out of his own pocket. This equates to approximately $145pw. Although this is a small outlay to purchase a large asset such as an investment property, he is still out of pocket.

After ten years this amount could equate to $75,000 in out of pocket expenses. And the only way he can make up for this is if buys in a good area and the property appreciates in capital value. He also can’t afford to pay too much for the property, which many have done in recent months.

To help explain my point I share the following example with Mario and Maria. In the last 18 months, Beecroft and Epping in Sydney have experienced tremendous growth. At the same time, just a few suburbs away, West Pennant Hills has hardly moved in 4 (four) years. Mario is shocked.

Still keen to go ahead and invest, he wants to know what approach he should take.

I recommend the following:
1.       Don’t buy an asset just for tax purposes only. It’s the wrong approach. In Nick’s case, he has to pay out $3 from his own pocket to save $1 in tax. It defeats the purpose.
2.       Location is still king, even more so if you use a negative gearing strategy.
3.       To benefit from negative gearing, you really need to hold the property for two property cycles (15 – 20 years). One cycle (7-10yrs) is often not enough to realise a decent profit and justify the headaches.

I explain to Mario that the reason Nick has done well is because his first priority was to buy in good areas. I.e good transport, education, hospitals, shopping centres. The tax benefits were a bonus.

Therefore, as much as the tax savings are nice, location is more important. That’s why I wouldn’t buy a property or any other asset just for tax purposes.

Mario turns to Maria to ask her a question in Italian. Turns out he wants to invite Nick over for dinner to make amends. Smart move because Nick reckons Maria is the best cook outside Tuscany!

Have a great week!

NSW to win by 2.

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This information has been prepared without taking into account your objectives, financial situation or needs. Before making a decision based on this material, you should consider its appropriateness in regards to your objectives, financial situation or needs. You should seek advice about how the relevant laws impact on your particular circumstances. Suncow Wealth Pty Ltd is a Corporate Representative No.441116 of AFSL 393254.