Understanding Negative Gearing
In Australia, investment properties are allowed tax deductions from losses – called negative gearing.
Negative gearing is a financial strategy that involves borrowing money to invest, typically in real estate or shares, intending to generate a return that exceeds the borrowing costs.
It’s a concept commonly used by investors to leverage what a property costs each month against how much revenue it generates.
Let’s break down negative gearing’s basics, how it differs from positive gearing, and if negative gearing could save you money in the long run.
What is negative gearing?
First of all, gearing is a financial jargon referring to how an investor borrows money to buy assets.
There are two kinds of gearing: positive and negative gearing.
Positive gearing occurs when the income generated from an investment exceeds the costs of owning and financing that investment. In the context of real estate, positive gearing refers to rental properties where the rental income surpasses the property-related expenses.
Negative gearing, on the other hand, happens when the income generated from an investment, in this case a rental property, is lower than the cost of owning and financing that property. Owners can offset the expenses through tax benefits. Mortgage repayments, property maintenance, and management fees are calculated to determine the reduced taxable income.
How positive gearing differs from negative gearing
Positive gearing simply refers to a situation when the rental income generated from the home is more than the amount you are spending to keep the property. For instance, if your investment property earns $30,000 a year from rent, and your expenses in total (which includes mortgage repayments, maintenance, corporate fees, etc.) are only $25,000, you have a positive annual cash flow of $5,000.
There are obvious perks to positive gearing. Your investment property is paying for itself, so the overall debt is reduced per year. Also, the cash proceeds can be a financial buffer for your situation. And having a positively geared property increases your borrowing capacity to venture into other properties.
However, positive gearing won’t receive the same tax incentives as negative gearing. In fact, as you increase income earned from the rental property, you’re also increasing the taxable income. It’s also a slower approach to equity growth, especially when looking at your capital gain appreciation.
Let’s now learn what separates negative gearing from positively geared investments.
How does negative gearing work?
It sounds unusual that an investor would benefit from the property losses. But negative gearing is designed for this purpose.
The Australian Taxation Office (ATO) deems that the tax result of your property as a net rental loss, for which you can claim the deduction for said loss. Negative gearing effectively brings down the total taxable income for the year.
What expenses can be claimed on negative gearing?
Negative gearing allows deductions on the part of the investor. These include:
- Loan interest
- Lenders Mortgage Insurance
- Mortgage broker fees
- Loan establishment fees
- Stamp duty
- Council fees
- Bank fees
- Depreciation
- Rent advertising
- Legal expenses
- Land tax
- Property management expenses
- Insurance
- Unpaid utility bills by tenant/s
What are the pros and cons of negative gearing?
Let’s start with the advantages:
Tax benefits – One of the primary advantages of negative gearing is the potential tax benefits it offers. The shortfall between rental income and expenses can be claimed as a tax deduction, reducing the investor’s taxable income. This can result in a lower overall tax liability and potentially increase cash flow.
Capital growth potential – Negative gearing is often considered ‘the long game’ employed in the hope of capital appreciation over the long term. You expect that the property’s value will increase over time, generating a profit when it is sold after, say, 7-10 years. This potential capital growth can be a significant advantage for investors looking to compensate for the losses in cash flow and later on build wealth.
Long term tenants – Negatively geared properties are usually located in high-demand, metro areas, and so offering lower rental rates could keep your tenants staying on for the long haul.
Now let’s discuss the downsides of negative gearing:
Cash flow requirement – Experiencing a loss each month means you need to have other income sources to cover property costs while you haven’t claimed tax benefits. You’ll be on a shortfall until tax time.
Potential capital losses – Even if you are intent on building equity with the investment property, sometimes the market takes a downturn and interest rate hikes happen. Interest rates often see house prices take a hit, which could affect your capital gains.
Vacant property – When you’re planning to negatively gear, you’re accepting the monthly loss. But it’s doubly impactful if your property is vacant and remains so. You’ll more likely shoulder compounded costs from mortgage and maintenance costs.
Learn more about negative gearing Australia
Negative gearing relies on the expectation of capital growth in the investment property to eventually generate a profit upon its sale. However, this is not always the scenario. It’s a viable strategy if you have multiple income streams and can comfortably sustain yearly shortfalls, and you have the knowledge on property market.
However, it also carries the risk for big losses. It’s best to consider your finances, risk appetite, and market insight.
Negative gearing may or may not be an appropriate strategy for your investment property. Let our mortgage experts at Intellichoice do the legwork on finding out how negative gearing could impact your monthly and yearly costs, portfolio, and long-term financial goals. Consult with our team today to get started.
