What is negative gearing and how does it work?

• Negative gearing is a property investment strategy with the potential for large capital growth. How exactly does it work?
• What are the tax implications related to negative gearing, and how does the market influence the success of this strategy?
• How negative gearing compares with the lesser-known positive gearing strategy.

You have probably heard about negative gearing if you are thinking about getting into property investment. But you may be wondering why any investor in their right mind would be attracted to anything explicitly deemed as negative.

You aren't the first and you won't be the last person to ask what negative gearing is or how it works. This guide contains an easy-to-understand explanation of what the benefits and drawbacks are, plus lays out an example of negative gearing in action.

What is negative gearing?

Negative gearing is a property investment term used when you take out a loan to purchase real estate, and the property makes a loss. This is because negatively geared properties have a lower rental income than the cost needed to maintain them.

Investors usually buy property to make money and not losses, so why would you consider investing in a negatively geared property?

How is negative gearing beneficial?

Negative gearing has several benefits to the investor, which is why it has become such a sound investment strategy over the years.

Australian law dictates that investors can deduct the losses they make on an investment property from their taxable income. This is the main benefit of negative gearing — it can make investing in property much more accessible.

Most investors who purchase rental properties expect to profit from long-term capital growth and not from the rental income. So they hope to sell the property down the line for a significant profit.

Negative gearing works when the money made from a property’s capital growth is more than the losses on the monthly rental and expenses.

Negative gearing doesn’t require you to pay tax and saves you from paying tax on some of your taxable income. In fact, because you make losses on your investment, you may be eligible for tax deductions and may be able to claim several of your investment property expenses.

This is what makes negative gearing so attractive to investors. The minimal losses they make in the short term are heavily outweighed by the long-term capital growth and subsequent profit.

How much tax do you get back from negative gearing?

As per the Australian Taxation Office (ATO), a negatively geared property has a lower net income than the cost of owning and maintaining the property.

The amount of tax you get back from negatively geared properties depends on:

• the property's purchase price;
• the amount of the loan;
• the duration of the loan;
• your loan's interest rate and repayment option (principal and interest, interest only);
• your gross personal income (before tax) and your rental income;
• fees associated with the property (council rates, strata fees, insurance, repairs and maintenance and so on).

You can consult with an expert to make an informed investment decision.

How does the market influence negative gearing?

The government's policies on negative gearing significantly impact the availability of rental housing. Because negative gearing benefits make investing in rental properties so accessible, investors have flocked to these properties.

The main driver of negative gearing is the property's long-term capital growth potential. As the market fluctuates, the property’s growth may plateau. This is the most significant risk involved with negative gearing.

Is negative gearing a good or bad idea?

There isn’t a specific answer to whether negative gearing is good or bad. That being said the Australian Financial Review (AFR) reported that around 60% of investors are negatively geared.

The AFR’s report also states that this number is decreasing and is now the lowest since 2004, which indicates a decline in interest rates. As mentioned by the AFR: “The decline in negative gearing coincided with the Reserve Bank of Australia cutting the overnight cash rate to 1.25% by June 2019 – back then a record low.”

So even though the majority see negative gearing as the way forward, it’s recommended to speak to a financial advisor to evaluate its viability for your financial goals.

Pros and cons

Can you negatively gear your own home?

Since “gearing” indicates borrowing money to buy a property for investment purposes, you cannot do this for your home. It isn’t possible to negatively gear your home since it isn’t an investment property for you. You aren’t necessarily receiving monthly rental income for your own home, so you can’t claim tax deductions.

However, you could negatively gear a holiday home that you rent out for most of the year. To evaluate the gearing, you would have to separate the maintenance costs between rental use awith higher rental incomend personal use.

Positive gearing vs negative gearing

Positive gearing indicates a property where the rental income is higher than the expenses. Since you make a profit on the property, you will have to pay tax. The amount of tax you must pay depends on your marginal tax rate. This strategy aims to make money through rental income, which leads to an increase in cash flow.

Negative gearing indicates a property where the expenses exceed the property's rental income. The investor who chooses this property aims to make money from long-term capital growth.

They initially lose money on the property and may have to pay out of their own pocket to cover some expenses. This allows them to claim tax deductions from their income tax. After a certain period, they can try to sell the property for much more than what they paid.

An example of negative gearing

Let’s say an investor pays $520,000 for a property and takes out a $500,000 property investment loan with a 7% interest rate. The loan's annual interest payment is $35,000. The investor charges $550 per week in rent, for a total of $28,600 in annual rental income.

According to the numbers above, the investor pays $35,000 in interest but only earns $28,600 in rent, resulting in a $6400 rental deficit every year.

This indicates that they are losing money on their investment and that their property is 'negatively geared.' According to Australian legislation, the investor can deduct this amount from their taxable income, resulting in a $6400 reduction in their taxable income.

They would pay lower taxes as a result.

Final thoughts

In light of the points discussed in this article, there are a few key points to bear in mind. First, the best way for negative gearing to work is within a climate of rising prices.

It’s also best at the top income tax rates since these brackets give the biggest tax breaks. Finally, it’s a strategy that relies on the tax law remaining as it is.