Half of Australia’s business is taxation. Most wage slaves rarely consider that once you hit about $38,000, 47c in every dollar goes in income tax. Passed on sales taxes, petrol, booze and tobacco taxes and wholesale taxes make up the rest.
Companies pay similar amounts. People on $50,000 or more pay slightly more (48{ per cent after the Medicare tax). In theory. A recent survey of people earning more than $1 million a year, however, showed they paid an average of 26 per cent of the their income in tax. Huh? With a marginal rate of 48{ per cent, shouldn’t they be paying a little more? No. They use tricks to minimise their tax. These tricks can legitimately be used by non-millionaires, like you an me. The main one is negative gearing, usually on real estate. This is how and why it works.
It is based on the assumption that governments will behave stupidly. If governments behaved intelligently, negative gearing on real estate would go out the window in Australia and savings and investment would be chanelled to better things.
The four policy failures (five if you are talking about Canberra) that governments can be relied upon to follow are: high immigration, no taxing the family home or unvested wealth, a failure to control inflation and continued taxation of savings income. The fifth in Canberra is a failure to curb the growth of the federal public service.
These failures result in a higher immigrant population (and public-service population in Canberra) putting pressure on urban land. It becomes rarer and the price consequently goes up. As Mark Twain said: Buy land young man they are not making any more of it. Coupled with tax and inflation policies, the environment is ripe for negative gearing, and probably always will be.
Step One: Buy your first home as quickly as possible. Even if it is a shoebox needing a lot of work, buy something. Do not save any money. Pay your home off first. Investment advisers hate this advice because they do not get any commissions. But paying your home off is the best investment: it can be done in dribs and drabs; there are no fees; there is no tax on the nominal earnings; and it is as safe as. well, houses.
When it is nearly all paid off, or if your home is already nearly all paid off you can start negative gearing.
Say your present house is worth $150,000 and you owe, say, $30,000. Look for a house to buy worth about $145,000. Borrow the whole lot, raising $60,000 on your own home and $90,000 on the new one, leaving $5000 for farnarkling fees (lawyers, greedy governments taking stamp duty and the like). Money raised for the purposes of making an income is tax deductible; it does not matter that you happened to use your present home as security to raise than money.
The rent, say $10,000 a year, plus your own contribution of $8000 a year will cover interest payments and out-goings. The $8000 is tax deductible, so you get $4000 back. The “”lost” $4000 goes to money the investment house “”owes” you.
As the years go by you can increase the rent indefinitely. However, the interest (over time) averages in a static way. For example, rent on a lower-end Canberra house has gone from about $100 to $180 in the past 11 years, whereas interest has averaged slightly under 16 per cent. Moreover, the value of the investment house will constantly rise (in Canberra at least).
The accompanying tables and graph show the averaged pattern in Canberra at the lower end of the market from 1982-1992. This embraces two recessions and two high-interest shocks. It embraces two or three high vacancy times and two or three landlord-take-all times. There were also two periods of rapid price increases and two doldrums. Inflation has slowly dropped over the period. But averaged out you can see the money is there to be made.
Where did these magical figures come from? A combination of the Real Estate Institute of Canberra, the Australian Bureau of Statistics and personal experience.
The bureau’s figures (the most reliable of the three) say inflation went up an average of 6.2 per cent. The institute says house prices went up an average of 9.8 per cent per year and 11.1 for units and townhouses. Personal experience suggests that the institute’s figures are optimistic and the house that mugginges like you and I might buy will only go up by 8 per cent. (If I bought a kangaroo it wouldn’t hop.)
None the less, even at 8 per cent, the money is there to be made.
Don’t be daunted by the tables. They are worth poring over, not only because I have spent a long time creating them (with a little help from Excel 4) but because they show how negative gearing works. The graph is a little simplistic, but it, too, illustrates the point.
Some explanations: The tables show over 11 years what happened to a house at the lower end bought in 1982 for $55000 using in one table the institute’s 9.8 per cent and in the other table a more pessimistic 8 per cent. The inflation rate shows the effect of inflation on that $55000.
The outgoings start at $2000 a year and are indexed. They include an amount for land tax as if it had been in force since 1982. The first year includes start-up fees of $2000 (which was about the cost then, though it is much higher now), thus the cumulated outgoings in the first year are $2000 than normal out-goings. Rent is indexed at the inflation rate, so you don’t have to behave like a greedy slum landlord.
There are no allowances for periods without a tenant or for real estate fees, but the out-goings are fairly generous.
The cumulative tax break assumes a marginal rate of 50 per cent and is the outgoings plus interest minus the rent divided by two.
These figures are then used to calculate what the house “”owes you”. This is subtracted from its value (increasing at 9.8 per cent or 8 per cent a year) to give you a profit or loss. Four per cent of the house value has been knocked off this to allow for selling fees. Selling fees are calculated on the rule that whenever large sums of money change hands you will find a lawyer, the government and an agent of some sort taking their cut.
The tables and the graph show that in general you are behind for the first four or five years, then your profits go up dramatically. There comes a time when rent outstrips outgoings and interest, usually after 10 years or so. At this point you are no longer negatively geared. The house would be making a profit from rent each year, upon which you will have to pay tax and provisional tax. This is not a good idea. Giving money to the Government is silly; it will only waste it. It is time to buy another negatively geared house. This process continues until early retirement when you no longer have a large taxable income requiring reduction through negative gearing. Then you live off the rent.
If you sell an investment house, you are up for capital gains tax, which will cut your profit as follows. Look at the last column in the 9.8 per cent table for example. The house sells for $140,083. Capital gains tax makes an allowance for inflation, so the gain is not $140,083 minus the original $55,000, but $140,083 minus the inflated value of $100,371. In round terms, that’s $40,000. Your tax is thus $20,000. This is why you do not sell, at least until you are not earning a big wage income or until Dr Hewson abolishes the tax.
A warning: this is a long-term project. Inflation rates and real-estate values do not go up or down at an even rate and interest rates do not stay on an even keel. If they did, we would not have economists. Thus you might buy when house values are up, rents down, interest low and inflation low. Suddenly a politician makes a reference to a banana republic, and you are looking pretty silly, especially if you can’t meet the increased interest rates. When you buy ask yourself the question: what if interest rates went up to 21 per cent? Could I continue to pay, even if living on sausages and mash? If not, don’t go ahead.
You could get caught with a big repair bill. You might be forced to sell when prices are low and so on. This is called risk. Welcome to capitalism.
In general though, it works. The experience I had with a house bought in O’Connor around that time, falls somewhere between the institute’s 9.8 and the pessimistic 8 per cent, though in early 1984 for a time I was cursing ever buying it.
Don’t worry about Dr Hewson. He has threatened to cut immigration, cut the public service and cut Canberra. So did Phil Lynch during the Fraser years. A repeat of a 10-part documentary now running on the ABC shows that these things will not happen. I think the documentary is called üYes, Minister or something like that. It explains why governments cannot cut bureaucracies, and one whole episode is devoted to how whole bureaucracies cannot be moved to inhospitable climes, though from time to time a few will be moved causing huge outcries in gross disproportion to their effect on real-estate values.
A last point. Remember the three fundamentals of real estate when buying: location, location, location. And those three locations are not Outer Gungahlin, Outer Tuggeranong or West Belconnen.