What is negative gearing?
Negative gearing refers to the financial practice where an investor borrows money to invest in a property and the cost of the loan’s interest is greater than the rental income said property generates. So, to break this down into its most simple terms, negative gearing means interest on loan > rental income.
To give you a more ‘real world’ example, let’s say you bought an investment property which you rent out to a tenant for $20,000 per year, but the interest payments for the loan you used to buy it are, in fact $25,000 per year. The property is categorised as ‘negatively geared’ because you are making a yearly loss of $5,000.
Why do it?
Yes, you heard us right. By negatively gearing the property you are making a loss. So, why would anyone do this?
Let us explain.
In Australia the loss you make from your investment property can be used as a tax deduction against your other taxable income, thereby reducing your overall tax payable.
If for example, you earn a $60,000 salary working as a graphic designer and you negatively gear your hypothetical property investment (the one we spoke about above) your taxable income would be reduced by your loss ($5,000). This results in you paying tax on $55,000 instead of $60,000.
Ok, we know that sounds as if you’re only getting a tax deduction of $5,000 and not making back $5,000. So it seems a bit pointless.
But let us explain, further.
The point of negative gearing is that hopefully you’ll make a capital gain on your investment property when you sell it one day for more than you bought it and, in the meantime you’ve at least minimised the loss you make on the property on an annual basis by offsetting the yearly loss against your taxable income.
In other words, negative gearing is about the long term play. It’s about minimising loss in the present so one day in the future you’re able to sell your investment property for way more than you bought it for!
Negative gearing in a nutshell
- Interest on loan> rental income generated from investment property=negatively geared property
- Negative gearing is a way to minimise loss on an investment property by offsetting that loss against your taxable income, meaning you reduce your yearly tax
- Before deciding whether to negatively gear a property it is vital to have a comfortable cash flow position to be able to fund the loss
- Negative gearing is a practice that can ‘pay off’ if you have the financial security and patience to make a loss for some time and then sell when the property has appreciated in value
Negative Gearing: The Pros
- Capital growth: as long as you’ve invested in a location with strong future growth and sell at the end of a market cycle - generally, 7-10 years, your gains should make up for your incurred losses
- Negative gearing a property by keeping rental prices lower than average can help to keep long term tenants
- With the help of your financial advisor or tax accountant you can claim a range of losses to decrease your tax
Negative Gearing: The Cons
- Tighter cash flow means you’ll have less money to spend overall, this is why it is important to think about your cash flow and employment situation before you jump in to negatively geared investments
- Tighter cash flow also means less borrowing power - this could hamper your attempts at growing a property investment portfolio
- You will get taxed on capital gains when you eventually sell the property
Tips for buying a negatively geared property
The whole point of negative gearing is to eventually sell the property at the end of a market cycle - gaining back all the money you’ve lost and then some. So, how do you ensure that you invest in the right property; one that will appreciate rapidly?
There’s no way to absolutely guarantee it but there are definitely some factors that can help you make an informed decision.
- Work with a buyer’s agent to understand the suburb you want to invest in - is it close to transport, shops, amenities and a city centre?
- Look at sales data for that specific area; how have rental properties in the area performed over the last decade?
- Explore the neighbouring suburbs of the area you wish to invest in - what do they offer?
- Find out if there is planned infrastructure in the area, are their works happening within the next few years to improve the current amenities?
All these factors can give you hints as to what the suburb will look like in a few years time and whether it will be a more sought-after location. Buyer’s agents are a great option especially if you don’t know where to start! They can help you analyse all this information and will make any property investment decision much easier.
Want to run through some more hypotheticals? We’re here to help. Get in touch through our contact page.