Negative gearing is one of the most misunderstood concepts in income tax and is something commonly said in the media without any real explanation.
Simply, gearing is “borrowing to invest”. It allows you to invest more than what you currently have, which then means you gain more profit if it’s successful. Conversely, it will mean your losses are greater too.
Negative gearing is the concept of using interest costs as a deduction against the annual taxable profit of the asset. Using an investment rental property as an example (as this is the most common asset that is geared);
After taking into account tenant income, and adding the costs of the property (rates, water, repairs, advertising, real estate commission) to the interest paid for the year, an investor will almost always come out to a negative figure. This means during the year you have had to pay actual cash out of your bank to keep the rental property afloat. This cost out of your pocket can be used as a tax deduction against your salary & wages income, which then saves you income tax.
What is Negative Gearing?
Negative gearing is an investment strategy where the expenses associated with owning an investment asset, such as a rental property, exceed the income generated by that asset. In other words, the investment is running at a loss, and the investor must cover the shortfall with their own funds.
Here’s how negative gearing typically works:
- Expenses: The expenses related to the investment property may include mortgage interest payments, property management fees, property maintenance costs, insurance, property taxes, and other expenses. These expenses are deducted from the rental income received from tenants.
- Rental Income: The rental income generated by the property is typically the primary source of revenue. However, if the expenses exceed the rental income, there is a negative cash flow, resulting in a loss.
- Tax Benefits: In some countries, such as Australia, the United States, and the United Kingdom, investors can offset the losses incurred from negatively geared investments against their taxable income. This means the investor can deduct the losses from their other income sources, such as wages or salary, reducing their overall taxable income and potentially lowering their tax liability.
The rationale behind negative gearing is that investors aim to benefit from potential long-term capital appreciation of the investment, which may outweigh the short-term losses. The hope is that the property value will increase over time, generating a capital gain upon sale that surpasses the accumulated losses.
Key points to consider about negative gearing:
- Tax considerations: The tax benefits associated with negative gearing can reduce the overall financial impact of the losses incurred. However, the exact tax implications vary depending on the jurisdiction, tax laws, and individual circumstances. It’s important to consult with tax professionals or financial advisors to understand the specific tax implications of your situation.
- Cash flow implications: Negative gearing requires investors to have sufficient cash flow to cover ongoing losses. It’s crucial to assess your financial capacity to handle the negative cash flow and any unexpected expenses that may arise.
- Market conditions: The success of a negative gearing strategy relies on the assumption of future capital appreciation. It’s important to thoroughly research the market conditions, considers historical trends, and assess the potential for growth in the investment property’s location.
- Risk factors: Negative gearing carries risks, particularly if the property value does not appreciate as expected or rental income decreases. Investors should carefully evaluate the risks associated with the investment and ensure they have a contingency plan in place.
Overall, negative gearing can be a viable investment strategy for some investors, particularly those looking to offset taxable income and benefit from potential capital appreciation. However, it’s crucial to seek professional advice, conduct a thorough analysis, and consider individual circumstances before pursuing a negative gearing strategy.
What Is Positive Gearing?
Positive gearing is an investment strategy where the rental income generated by an asset exceeds the costs associated with owning and maintaining that asset. In simple terms, it means that the investment is cash flow positive, and the investor receives more income from the investment than they spend on expenses.
In the context of real estate, positive gearing typically refers to rental properties. When the rental income from the property exceeds expenses such as mortgage payments, property taxes, insurance, maintenance costs, and management fees, the property is said to be positively geared.
Here are some key features and benefits of positive gearing:
- Cash Flow: Positive gearing provides a steady stream of income to the investor. The surplus rental income can be used to cover expenses, contribute to savings, or reinvest in other opportunities.
- Reduced Financial Risk: With positive gearing, investors are not relying solely on potential capital appreciation to make a profit. The rental income covers the expenses, reducing the financial risk associated with relying on future market conditions.
- Lower Dependency on Capital Growth: Positive gearing is not contingent on the property’s value increasing over time. While capital growth can still occur, it is not necessary for the investment to be financially viable.
- Potential for Higher Returns: With positive gearing, investors can generate a consistent income stream and potentially achieve higher returns on their investments. The surplus income can be reinvested or used for other purposes, providing additional financial flexibility.
- Easier Mortgage Serviceability: Positive gearing can make it easier for investors to obtain and service a mortgage for the investment property. Lenders typically assess the rental income when considering the loan application, and a positive cash flow property can demonstrate greater affordability.
Positive gearing can be an attractive investment strategy, especially for investors seeking regular income and a lower level of risk. However, it’s essential to conduct thorough research, analyse the market conditions, and consider individual financial goals before pursuing a positive gearing strategy. It’s also advisable to consult with financial advisors or professionals with expertise in real estate investment to make informed decisions.
Why Would You Want An Investment That Makes A Negative Gearing Loss?
Investing in an asset that generates a negative gearing loss, such as a negatively geared property, can have potential benefits for investors, despite the short-term financial loss. Here are some reasons why investors may choose negative gearing:
- Tax Benefits: One of the main reasons investors opt for negative gearing is to take advantage of tax benefits. In many countries, including Australia, the United States, and the United Kingdom, investors can deduct the losses incurred from negatively geared investments from their taxable income. This reduces their overall tax liability, potentially resulting in a higher tax refund or a lower tax bill.
- Capital Growth Potential: Investors may be willing to accept a short-term loss in exchange for the potential long-term capital growth of the investment. Real estate, for example, has historically shown the potential for appreciation over time. If the value of the property increases significantly in the future, it can offset the losses incurred during the negative gearing period, resulting in a net gain.
- Leverage: Negative gearing allows investors to leverage their investment by borrowing money to purchase the asset. By borrowing funds and using the rental income to cover part of the expenses, investors can acquire a more expensive property than they could afford solely with their own funds. This can potentially lead to higher returns in the long run if the property value appreciates.
- Portfolio Diversification: Negative gearing can be a strategy for diversifying an investment portfolio. By investing in an asset class like real estate, which behaves differently than other investments like stocks or bonds, investors can spread their risk across different sectors and potentially reduce overall portfolio volatility.
It’s worth noting that negative gearing is not suitable for everyone and carries risks. It relies on assumptions of future capital growth, and the investor must have sufficient cash flow to cover the ongoing losses. It’s important to carefully assess the investment strategy and seek professional advice to ensure it aligns with your financial goals and risk tolerance.
Understanding the differences between negative gearing and positive gearing is crucial for investors seeking to make informed decisions about their investment strategies, particularly in the context of real estate.
Negative gearing offers the potential for tax benefits and the prospect of capital appreciation, but it requires investors to cover the ongoing losses with their own funds. It carries risks and relies on market conditions and future property values.
On the other hand, positive gearing provides immediate cash flow and reduces financial risk by generating surplus income. It offers greater stability and does not rely solely on capital growth. Positive gearing can be an attractive option for investors looking for regular income and lower dependency on market conditions.
Ultimately, the choice between negative gearing and positive gearing depends on individual circumstances, financial goals, risk tolerance, and market factors. It is crucial to thoroughly research the market, seek professional advice, and assess one’s own financial capacity before deciding on an investment strategy.
Investors should carefully consider their long-term objectives, evaluate the potential risks and rewards, and ensure their investment aligns with their overall financial plan. By doing so, they can make informed decisions that best suit their individual needs and aspirations.