Negative gearing is a popular investing strategy for many Australian property investors. There are a number of benefits for investors who choose to take advantage of negative gearing. However, it’s important to know how it works and what other options exist before making a decision about which strategy might work best for your individual financial situation.
Different types of gearing
The word ‘gearing’ simply means borrowing money to invest. The investor pays interest on the loan amount taken to purchase the investment property.
When gearing is leveraged correctly, it can be a powerful financial tool for helping to build wealth, so it’s a popular option for many investors. The key to using gearing correctly in your investment strategy is to understand the types of gearing.
Negative gearing: When an investment property is negatively geared, it means the interest and associated costs of owning the property are higher than the rental income you receive from the tenants. The overall result is that the investment is making a loss.
Neutral gearing: Neutral gearing simply means that the interest charges and other associated expenses of owning the investment are equal to the rental income being received.
Positive gearing: When an investment is positively geared, it means that the interest and expenses are lower than the income received. The result is that the investment is making a profit.
The positives of negative gearing
The vast majority of people who get into investing do so with the intention of making a profit. So how can negative gearing be a positive investment strategy for building wealth?
Capital gains: The objective for many Australian property investors is to offset any losses made with a potential capital gain in future when the value of the investment increases. For example, if you purchase an investment property for $400,000 today and over the next two years the property value increases to $450,000, you’ve increased the value of your asset by $50,000 you didn’t have when you first bought the asset.
Tax advantages: If the costs of owning your negatively geared property outweigh the rental income it generates each year, the result is a taxable loss that could be offset against your other income.
For example, if you buy a $400,000 investment property and borrowed $400,000 at an interest rate of 5.5%, the annual interest payable on the loan is $22,000. By the time you pay property management fees, council and water rates, insurances and other associated expenses, let’s assume your total costs (including interest) come to $28,000
If you’re receiving $400 a week from your tenants, you’re generating a gross rental income of $20,800. The result is a net rental loss of $7,200, which can be used to potentially reduce the tax payable on your income.
Improve cash flow: If you already know in advance that your property investment is negatively geared and will record a loss over the coming financial year, it may be possible to apply to the Australian Tax Office (ATO) to reduce the amount of tax taken out of your wages. This is known as a PAYG withholding variation, which you give to your employer or payroll officer. The next time you receive your salary, the amount of tax taken from your income should be reduced, which can help boost your personal cash flow.
Is negative gearing the right investment strategy for you?
There are plenty of benefits to negative gearing, so it can seem like a great strategy for building wealth over a period of time. However, there are also some risks you need to take into account.
Negative gearing still means your investment is making a loss, which means the shortfall in costs needs to come from your salary. There is also the risk of interest rates rising, causing your expenses to increase. If you’re in a situation where you’re unable to raise the rent until the next time the lease is renewed, your income needs to cover the shortfall in costs.
It’s also important to take into account what will happen to your cash flow if your tenants leave and you struggle to find replacement tenants quickly. If the previous tenants left the property in a poor condition that makes it uninhabitable, it may remain empty for a longer period of time while you complete repairs and maintenance.
Fortunately, there are ways to mitigate the potential risks of negative gearing. Be sure to manage your income and expenses carefully and protect yourself and your investment at all times against any foreseen problems.
The key to determining the right investment strategy for your individual financial situation is to discuss your goals with an expert and seek professional advice. Discuss your financial needs with a mortgage broker. Ask your accountant about how owning a negatively geared investment property could impact your finances at tax time, and speak to a financial advisor about your overall investment strategy.