Few aspects of property investing attract as much media attention as negative gearing.
And even though a lot of people are willing to offer strong opinions on whether it’s good or bad for us, few people actually understand how negative gearing actually works.
With that in mind, we’ve developed this guide to understanding negative gearing – what it is, why it exists and how it can work for you.
How negative gearing works
The term ‘gearing’ refers to when you borrow money to buy an asset, whether that’s property, shares or something else. So when an asset is negatively geared, it means that the cost of borrowing – and other related expenses, such as depreciation and strata fees – is higher than the amount of income that asset generates. In other words, negative gearing means that your investment is running at a loss.
Obviously, not all properties are negatively geared. If you don’t have a mortgage or if your expenses are less than the income your investment property generates, it’s said to be positively geared.
And, when the cost of borrowing equals the amount of income generated, it’s known as neutral gearing.
Why would anyone choose to make a loss?
One of the main benefits of negative gearing is that it can provide you with a lower tax bill at the end of the financial year. That’s because the Commonwealth government lets you deduct losses from your total income when you report for tax purposes.
For example, assume you earn $100,000 a year from your job and $15,000 in rent from an investment property. You then spend $20,000 a year on investment property-related expenses, including interest repayments on your mortgage. If you have no other income or deductions, your taxable income would be $95,000 (i.e. $100,000 + $15,000 – $20,000) even though you’ve actually earned a total of $115,000.
At the same time as you get this tax break, you’re putting money into an asset that should appreciate, or grow in value, over the long term. So property investors use negative gearing as a way to take advantage of the capital growth property tends to experience.
As wages and inflation grow and rents rise, your investment property should also start to generate more rent and even provide you with a steady source of income, especially if you eventually pay off the mortgage. This means that many properties that start out negatively geared end up positively geared, generating an income and potentially making them a great way to help fund your lifestyle or retirement.
Should you negatively gear a property?
Whether or not you should use negative gearing to buy and own an investment property depends on your own circumstances.
If you’re looking for an immediate income, it’s probably not the right strategy for you. You’re better off attempting to positively gear any investment property you buy.
If, however, you’re looking to grow your long-term wealth at the same time as reducing your taxable income – and you have the resources to meet any interest rate hike – it could be a good strategy to help you grow your wealth. That said, you should also consider that the value of your property may not rise as much as you like and you could face higher interest repayments if interest rates rise.
You should always speak with your financial adviser or accountant before you buy to work out whether negative gearing is the right approach for you to grow your wealth.
If you’d like to know more about negative gearing or the current state of the Perth property market, get in touch.