What is negative gearing?
Gearing is a term used to describe borrowing to invest. There are different types of gearing, but negative gearing is the term you’ve probably heard most often. It is a popular investment property strategy in Australia, and it can also be used with other types of investments such as shares.
An investment is negatively geared if the expenses associated with it are greater than the income it generates.
For example, if you purchase an investment property and the expenses associated with the property are greater than the rental income it generates, the property is said to be negatively geared.
Similarly, if you borrow to invest in shares and the borrowing costs are greater than the income that the shares generate via dividends, the investment is also negatively geared.
Interested to know more about how negative gearing works for tax purposes? Then listen to Episode 7 of the ‘Small Business All Figured Out’ podcast where our Registered Tax Agents Corinne and Sheryl explain what is negative gearing and how it affects your tax return.
To listen, click play below:
What are the benefits of negative gearing?
Although on the surface negative gearing may appear to be an odd investment strategy, it can provide you with two major benefits:
1) capital growth can potentially more than offset the amount by which your investment expenses exceed your investment income.
2) it will result in you paying less tax. For example, there are many expenses associated with an investment property that are tax-deductible against your investment income, including:
- the interest on any funds you borrow to buy the property (unlike any interest you pay on your home mortgage, which isn’t tax deductible).
- management costs, such as advertising for tenants, council rates, insurance, property manager fees, accounting/tax agent fees and body corporate charges for units/apartments.
- repairs and maintenance.
- depreciation on furniture and fittings in the property.
All these investment property expenses reduce your overall taxable income (which includes the rental income generated by the property itself), and therefore your tax obligation. The taxman is therefore subsidising your investment. The higher your marginal tax rate, the greater the benefit that gearing will provide.
There are less tax-deductible expenses if you borrow to buy shares, though the interest can be deducted if the shares provide you with taxable dividend income.
Many investors build significant property portfolios through the effective use of negative gearing. Those properties can help them to secure their financial future, without placing a burden on their current lifestyle. Well-chosen investment properties provide ongoing rental income and capital growth over time. Australian real estate prices have a long-term growth trend, especially in highly desirable locations such as major capital cities.
It’s always important to choose an investment property in a good location, especially if you’re relying heavily on rental income to make your loan repayments. It’s easier to attract tenants in good locations. Good investment property locations tend to have the following characteristics:
- they are close to where many people work (e.g. inner suburbs near the CBD). Alternatively, they might have a desirable natural feature such as a waterfront location.
- they are close to good schools, shops, public transport and entertainment facilities.
- they have a good reputation (e.g. low crime, unemployment).
- they don’t have an oversupply of rental accommodation available.
It’s also important to be aware that if you’re pursuing negative gearing as an investment strategy, you need to ensure you have the cash flow to make your loan repayments.
What are the potential risks of negative gearing?
Gearing involves borrowing money to invest. It’s important to understand that there is always an element of risk with any investment, and this risk is magnified if you borrow to invest. The value of any investment can fall as well as rise. In general, the higher the potential investment return, the higher the associated risk, and vice versa.
If you use negative gearing as an investment strategy, it can magnify your losses as well as magnify your profits.
Other types of gearing
A property is positively geared if its income exceeds its expenses, though the tax deductibility of legitimate investment property expenses still reduces the tax obligation.
A neutrally geared property generates about the same amount of income as its expenses.
It’s important to understand that the gearing of an investment property can change over time. For example, a property may be negatively geared in the first few years when the tax-deductible interest expense on it is at its highest, but it may become positively geared over time as the debt decreases (and the rent potentially increases).
Tax implications of negative gearing
Negative gearing is a popular tax planning strategy because the tax losses that arise can usually reduce an investor’s other taxable income, resulting in a lower annual income tax bill (or an increased tax refund).
How Our Melton Mortgage Brokers Can Help You
At PAT Finance & Mortgage Broking, we can help you to decide whether a negative gearing strategy is appropriate for your individual circumstances.
We’re based in Melton, in Melbourne, and service nearby areas including Bacchus Marsh, Caroline Springs, Plumpton, Rockbank, Gisborne and Sunbury. We’ll take the time to understand your individual home loan needs and goals. We work for our clients, not for lenders and we’ll provide you with the best possible mortgage broking advice in Melton.
Finance your dreams, secure your future. Contact us today to book your free home loan assessment to find out how we can help you.