If you’ve ever considered property investment, chances are you’ve heard the term ‘negative gearing’. But do you really know what it means and how it could affect your investment strategy?
What is gearing?
Gearing means borrowing money to buy an asset. In terms of property, gearing means you’ve taken out a mortgage to buy an investment property.
What is neutral gearing?
Neutral gearing means that the rental income you receive for the investment property is the same as the amount you pay in interest charges. You’re not making a profit or a loss.
What is positive gearing?
Positive gearing means that the rent you receive is higher than the interest charges you pay, so you’re making a profit.
What is negative gearing?
Negative gearing simply means that the rent your tenants pay you is less than the amount you pay on interest charges for your investment mortgage. Overall, you’re making a loss.
Positive vs Negative Gearing
Even with an uncertain economy, rental yields are still expected to continue to increase in
most capital cities. As the population in these cities continues to grow, demand for housing will also increase.
However with the recent economic conditions this increase in demand has not been satisfied with an increased supply of housing, resulting in a shortage of housing stock.
Falling vacancy rates and higher rents have made it more difficult and expensive to find
rental accommodation. Like all good investments you first need to consider the property to be purchased. As with all property investments, location is the key consideration. Generally properties located within 20kms of the CBD with good train, bus and freeway access will offer stronger returns
Once you have researched your investment property, you will then need to decide on the gearing strategy that best suits you. This will be determined by your financial circumstances, retirement strategy, the level of your deposit, equity available, surplus monthly cash flow (income less expenses) and your acceptable level of risk. These considerations will clarify whether negative gearing or positive gearing strategies are most appropriate to your situation.
Is Negative Or Positive Gearing Best For You?
Here’s a brief description of both gearing strategies to help you identify with the possibilities of each. Positively geared properties are when the rental return is higher than your loan repayments and outgoings. Positive cash flow properties are self funding and are considered to be a conservative investment strategy that provides an income with exposure to the prospect of capital growth. Bear in mind that with positive gearing there is the potential that tax will be payable on the net income (after the consideration of depreciation and other tax deductions).
Positively Geared Properties
Positive gearing is beneficial when an individual does not have surplus cash flow to fund income losses during the ownership period or other income to offset losses.
Negatively Geared Properties
Negatively geared properties are when the rental return is less than your loan repayments and outgoings (placing you in an income loss position). There is however the underlying expectation that the accumulated losses will be more than offset by the capital growth on the property.
In this circumstance the rental return is not considered as important in the decision process. The key benefit associated with negative gearing is that the loss associated with the property ownership can be offset against other income earned, reducing your assessable tax income, thereby reducing your tax payable.
The result is that the cost of owning the property is being funded by your tenant (in the form of rent), the tax office (in the form of tax savings) and your surplus cash flow.
Ultimately most investors will aim to be positively geared in the long run. Generally high tax payers choose the negatively geared investment option to maximise their tax returns and benefit from the long term capital growth potential. Investors closer to retirement or in a lower income bracket may choose positively geared investments to maximise their income potential.
Negative gearing in action… How It Works
Let’s say you purchase an investment property for $450,000 and you borrow $400,000 from the bank at an interest rate of 5.5%. You would end up paying $22,000 in interest per year.
Now let’s assume you receive $400 per week in rental income. That’s a total of $20,800.
At first glance, it can appear as though you’re only making a loss of $1,200 per year. However, you also need to factor in all the other costs associated with owning an investment property.
For the purpose of this example, let’s assume you’re paying council rates, water rates, landlord’s insurance premiums, and property management fees at a total of $5,800 per year.
Overall, in this example you’d be paying the shortfall of $7,000 per year to own that particular rental property and that you fund out of your own pocket.
How is negative gearing a positive?
Obviously, no one enters into an investment decision with the sole intention of making a loss. However, there are other benefits to owning a negatively geared property.
The cost of purchasing a residential property in Australia means that most investors start out with a negatively geared property. Over time, the rental income should increase, which can help reduce the shortfall between rent received and interest paid.
There is also the benefit of capital growth. If the capital growth of the property is greater than the loss you make in rental shortfall, negative gearing can be profitable overall.
In the previous example, we looked at a property with a potential loss of $7,000 per year. However, if you assume the property you bought was in an up-and-coming location and saw 5% capital growth over the year, your investment could potentially be worth $472,500.
While you might have been negatively geared to the tune of $7,000 in that year, your property could potentially have grown by $22,500 in value over the same period of time and that’s the philosophy of negative gearing – the short-term outlay to hold the property is offset over time by the capital gain and increasing rental returns generated by the property.
Tax benefits of negative gearing
There may also be some tax benefits available for investors who take advantage of negative gearing. If the tax office determines you’re making a loss on your investment property, they may allow you to deduct the shortfall of costs you’ve contributed from your own pocket from your taxable income. As a result, you could end up paying less tax.
Always take the time to speak with a good accountant so you can maximise any potential tax benefits associated with owning a negatively geared property.
If you aren’t sure where to begin with your investment property portfolio, call the specialists at Nieuvision on 1300 832 554. We’ll help you create a property investing strategy that can help you achieve your financial goals.
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Disclaimer: We recommend that you seek independent financial and taxation advice before acting on any information in our articles and newsletters. They contain general information only and have been prepared without taking into account your personal objectives, financial situation or needs. We recommend that you consider whether it is appropriate for your circumstances. Your full financial situation will need to be reviewed prior to acceptance of any offer or product. Interest rates are subject to change without notice. Lenders terms, conditions, fees & charges apply.