Negative gearing has its benefits but know the risks.

Let’s face it: hundreds of thousands of investors are attracted to property because of the tax breaks. According to the Australian Taxation Office, more than 1.1 million people claim negative gearing deductions yearly and receive tax benefits to the tune of $5.5 billion.

Having a negatively geared property allows you to deduct an investment loss from your income, including your salary, but it shouldn’t be seen as a panacea for a dud investment choice. There are smart ways to use negative gearing, yet there are also hidden traps that can catch out the unwary and those who don’t research thoroughly.

If you borrow to buy a house or unit and the expenses are greater than the income, you are negatively gearing. The ATO gives you back a percentage of this loss, to the extent of your marginal tax rate (that is, if you pay tax at 37 per cent, you’ll get back 37 per cent of the loss).

Fledgling investors often seek advice about whether they should use a negative gearing strategy. But negative gearing and positive gearing are not ”strategies”; they are terms that describe a cash position.

An investor’s strategy needs to centre on the investment fundamentals, such as selecting the right property in the right area. How to fund it is a separate issue.

For most investors, though, the financial returns rely on long-term capital growth, so the total capital growth must cover the upfront cost of the property, all the holding costs and other fees, such as council rates and stamp duty.

Negative gearing gives you a tax break while you wait out the 10 or 20 years needed to achieve good capital growth.

It’s vital at the onset that you find a balance between your cash flow and your investment.

You need to decide early whether you’re comfortable paying a $30,000 or a $15,000 shortfall out of your personal cash flow each year.

Also, consider what will happen if you lose your job or your partner stops working.

The risks of negative gearing can be the difference between a good night’s sleep and lots of tossing and turning.

The structure you use to hold a property affects tax, too. A property held in a family trust can’t claim any negative gearing benefits because a trust isn’t a tax-paying entity.

You can tap tax benefits by forming a hybrid discretionary trust, in which a family trust is established alongside a unit trust. But the most common and beneficial structure for investors is to use an individual title to hold property. It’s here that the benefits of negative gearing are most prevalent, especially if you’re paying the top marginal tax rate of 45 per cent.

Another trap to watch out for is using negative gearing for property held in a self-managed superannuation fund (SMSF).

Negative gearing is typically not suited to DIY super because the tax on income is 15 per cent or less.

In fact, the income tax paid on an SMSF can fall to nil, depending on the phase the fund is in. Capital gains tax is discounted by one-third then taxed at 15 per cent within the fund, which is another reason negative gearing should be avoided.

Negative gearing is often derided for inflating property prices. Critics regard the preferential tax treatment of investment property as middle-class welfare that should be scrapped.

Is this going to happen? Don’t put any money on it. No government that wants to stay in office will change negative gearing.

The stark fact is that there are 1.1 million voters who provide five out of every six rental properties in Australia and they expect a tax break to do the job.

Posted by Chris Tolhurst – The Age on 14th April, 2012