How Does Negative Gearing Work - Negative Gearing Explained

How Does Negative Gearing Work – Negative Gearing Explained

Investment properties and their gearing have become popular topics of discussion among investors. Negative Gearing in Australia is a very hot topic, especially for investors. Some individuals actively seek out negatively geared properties, believing it to be the best strategy to lower their taxes. The benefit of negative gearing cannot be understated for the average property investor.

However, I question the wisdom of intentionally aiming to lose money. Whilst Australia offers advantageous tax environments for property and share investments, I struggle to see the benefits of intentionally seeking out negatively geared properties for the sole purpose of tax reduction.

Moreover, I cannot think of many reasons, if any why I personally would intentionally look to find an investment property that is negatively geared just so I can ‘lower my taxes’. If an individual is taxed at 32.5% or 37% they will get $0.325 or $0.37 for every dollar that is negatively geared respectively back at tax time.

Whilst it is not for me to say if this strategy is for everyone, I did not intentionally look to buy a negatively geared property and would have happily purchased a positively geared property.

A positively geared property means that it is actively making you money. When you hear people discussing investment properties and they say: “an investment property pays its own mortgage”. News Flash! It doesn’t.

Let’s explore the concept of negative gearing and why it may not be suitable for everyone. As an investor, I did not specifically look for a negatively geared property and would have been perfectly content with a positively geared one. A positively geared property generates profit, providing a source of income.

However, it is important to debunk a common misconception: an investment property seldom pays for its own mortgage, at least initially. In the current market and interest rate environment, finding a property that generates income after deducting all expenses is becoming increasingly challenging.

Such residential properties may exist in regional centres or higher-risk investments, which I discuss in detail in my blog post on rental property yields.

What Is Negative Gearing And Positive Gearing? How Does Negative Gearing Work?

To explain the terms “negative gearing” and “positive gearing,” let’s delve deeper into their definitions. Gearing refers to borrowing to invest, using existing investments as collateral. It can be classified as positive, negative, or neutral. When it comes to property investing, the investment property itself serves as security.

Positive gearing is a term used to indicate that when all expenses are accounted for the property makes the investor money. This means that after all interest repayments, maintenance costs, property management fees and insurances the net rental income is positive. This additional income is then added onto that individual’s taxable income and will be subject to their marginal tax rate.

Negative gearing explained in simple terms, is when an investment makes a loss when all expenses and income are accounted for. In Australia negative gearing is a viable strategy for many investors due to current Government policies surrounding it.

When an investment property is purchased using borrowed funds up to 100% or 105%~ of the investment value, the position is often negative.

This position is often achieved when an investor draws equity from one property to use as a deposit on the new investment, with the other home loan being taken out against the new investment property itself.

This effectively creates two home loans which are both tax deductible if not mixed for other none income generating purposes. The overall taxation result of this property is negatively geared as there is a net rental loss.

Australian negative gearing has its tax advantages as much like its positive gearing counterpart, the net loss is taken into account on the investors taxable income. Thus, if an individual’s investment was negatively geared by for example $10,000 per year, this amount would be deducted from their taxable income.

Furthermore, if an individual was earning $100,000 they would have a marginal tax rate of 32.5%, so this $10,000 would equate to a tax credit of $3250 come the end of the financial year and they would be taxed on $90,000 instead of $100,000.

Lastly, neutral gearing as you may have guessed is when the investment property is neither negatively nor positively geared. These investments generally ‘break even’ and self-sustain themselves through the income they generate.

How Does Negative Gearing Work - Negative Gearing Explained

Cash-flow Positive but Neutral or Negatively Geared

Having now understood the various concepts surrounding gearing it is possible to have a cash-flow positive investment that is neutral or negatively geared.

Consider a property investment scenario where the net rental return generates a positive cash-flow of $2000 annually after considering all holding expenses. However, certain factors, such as a depreciation schedule, come into play.

A depreciation schedule enables investors to account for the wear and tear experienced by the property over time. To ensure accuracy, it is imperative to enlist the services of a qualified quantity surveyor to prepare the depreciation schedule.

In the aforementioned example, the quantity surveyor assesses that the property depreciates by $5,000 per year. This annual depreciation value subsequently affects the overall gearing of the property.

From a tax perspective, the property is now classified as negatively geared since the $5,000 depreciation expense is subtracted from the initial $2,000 net rental income. Consequently, the property’s annual income is -$3,000.

Long-Term Growth Potential vs. Rental Income

Investors often consider the long-term prospects of their investments and may prioritize appreciation over immediate income earned. Some assets, whether they are shares or properties, may not yield significant yearly income but can offer substantial overall growth.

For instance a property that is worth $500,000, it is negatively geared with a net rental loss of $10,000 per year. This property on paper may not look favorable to invest in.

However, if that investor has selected a good investment strategy that property may appreciate in 10 years time and be worth $900,000.

For the ease and simplicity in this example, we will assume that this property cost $10,000 every year to hold for those 10 years. Thus, resulting in a $100,000 total loss over that period (obviously negative gearing reduces that and the property rent would have likely increased during that period).

When that individual comes to sell that property, they will incur what is known as Capital gains Tax (CGT) (CGT will be covered in another post). In this example the investment property has appreciated $400,000 and only cost the investor $100,000 to hold in that time.

Thus, on a simplistic level this has resulted in a $300,000 profit (Not accounting for any CGT deductions, fees, charges or selling expenses).

This is why some investors will choose to hold properties that may be negatively geared in the hope that one day the property will appreciate well beyond what it costs for them to hold the investment.

Summary

There is no one size fits all strategy when it comes to investing. Individuals should find a strategy which suits their individual circumstances, goals and objectives. Individuals should seek financial advice specific to their needs to have a full understanding of which strategy may best suit their situation.

The impact gearing has on an investor will largely depend on their individualised circumstances and long term objectives.

Some investors are in a position where a negatively geared investment suits their situation whereas others require a positively geared or positive cash-flow investment to meet their needs.

Similar Posts