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Negative Gearing Explained

By September 30, 2018 No Comments

If you are an existing or potential investor, it is important to know exactly what negative gearing is and what benefits and risks it may bring.

Borrowing money to invest is known as ‘gearing’. Borrowed money can be invested in direct property, direct shares and also managed funds for example. It isn’t generally used to invest in cash or fixed interest (term deposits), as the returns of a geared investment need to outweigh the cost of borrowing (the loan interest rate) to make a profit.

If used correctly, gearing can propel wealth creation and make a substantial difference – mainly because an investor will have more money to invest from day one (and some tax benefits along the way, which reduces tax and help pays for the cost of the borrowings). This is known as ‘leveraging’ an investment.

Positive vs. Negative Gearing

When borrowing money to invest, we most often refer to investment properties. The income you receive from an investment property may be positive or negative.

When rental income is not enough to cover the loan interest and other running costs of a property, the property has negative cash flow and is therefore negatively geared. Conversely, when the rental return is higher than the interest payments and expenses, the property is positively geared.

It’s very common to have a negatively geared property initially, but after a few years (as rental income rises), the property should become positively geared. Whilst a property is negatively geared, it costs the investor money from their own pocket to hold the property (they pay the difference in costs) which can be a burden – the investor then counts on making capital gains (increases to the property value), to offset the income losses, so they still make a profit over the long-term.

Generally, if a property earns high rental income, then the capital growth may be low and vice versa, if a property earns high capital growth, then rental income may be low.

A good mix of rental income and capital growth makes the perfect investment. The aim with investing is not to hold too many negatively geared investments, for too long. Negative cash flow means you are losing money.With investing, you want tomake money!

The Tax Benefits

Under Australian Tax Law, as an investor earning income from a geared investment, you can claim a tax deduction for the loan interest costs, plus other fees and expenses associated with maintaining the investment.

The main benefit associated with negative gearing is that the negative cash flow (the loss) can also be claimed as a deduction and used to offset other income, such as the investor’s salary, to reduce tax payable.The tax savings achieved, can then enable an investor to afford a negatively geared investment in the early years, until such time as the property becomes positively geared.

Table 1: Example of Negative Gearing

In this example, the investor (Amanda) will pay around $4,077 per year ($78 per week) less tax whilst her investment property is negatively geared. That $78 per week then goes towards reducing the negative cash flow as follows:

$153      Negative cash flow

-$78      Less tax refund 

$75       Reduced negative cash flow

Paying $75 per week to hold an investment property is more affordable than $153 per week. The tax benefits associated with the negative gearing, make it more affordable to the Amanda and gives her time to hold the investment until it becomes positively geared (and starts to make her money over the long term).

The aim is to buy an investment property which is not too negatively geared otherwise it’s can be a strain.

Important To Know

While negative gearing can bring tax benefits, investing needs to be more than tax cuts.The aim with investing is to have investments with positive cash flow as soon as possible and which increases in capital value over time.

For example, positive property income will increase purchasing power by putting money into your bank account, which you can use to service the loan (or make extra repayments).

Gearing can be risky business and is not for everyone, usually higher-income earners (benefit more from the tax breaks), that are prepared to take on higher-risk and with a long-term investment timeframe (5 – 7 years plus) but, in saying that, there are plenty of people who may not necessarily feel comfortable borrowing money to invest in shares, but would have no hesitation to borrow for an investment property… or their own home.

As with all investments, the strategy should be consistent with personal circumstances and risk appetite. If you are considering investing, you should consider talking to a Financial Adviser and Accountant.

Disclaimer: This information provided is general in nature. It is based on the knowledge and experiences of the author and not intended to be taken as financial advice. It does not take into account the objectives, financial situation or needs of you or any other particular person. You need to consider your financial situation and needs before making any decisions based on the information. You may have to modify the information and do further research, for it to suit your personal financial situation. Therefore, before acting on the information, it is recommended that you consider its appropriateness to your circumstances or consult a financial adviser, tax advisers or legal professional to assist you in doing this.

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