In the context of property investment negative gearing occurs when the monthly income from your rental property does not cover all the expenses associated with the investment.
It is important to understand negative gearing, especially if you are thinking of becoming a property investor as it has implications for your financial circumstances.
Our Q&A article will define negative gearing, explain how negative gearing works, weigh up the pros and cons, and answer the most common questions about it. You can then make an informed decision if it is right for your investment strategy.
Before we look at negative gearing in more detail, let’s clarify what gearing is.
Gearing is simply a financial term which means borrowing money to buy an asset, like a property. So if you purchase a property with a home loan you will have taken advantage of gearing.
The question to ask is if you are positively or negatively geared?
Negative gearing is when the income from your rental property does not offset all the outgoings or expenses - so you make a loss from your investment. This is also known as negative cash flow.
The most obvious impact of being negatively geared is that you will need to cover the shortfall between the cost of owning the investment property and the income you receive from it.
You can use a simple 3 step formula to work out if you will be negatively geared by calculating your:
If your expenses exceed your income then you make a loss on your investment, and are negatively geared.
Analysis by the Department of the Treasury found that 68 per cent of individuals who earned income from a rental property in Australia were negatively geared. In other words, the majority of investors are making a loss from their rental property investment.
Positive gearing is when the rental income from your investment property generates more income than expenses before tax - so you are making a profit. This is also called positive cash flow, and means you will be making an ongoing net profit on your investment.
Department of the Treasury data indicates that close to 30 per cent of Australian property investors are positively geared - with ongoing income earned higher than their expenses.
Making a loss may sound counterintuitive, because the objective of an investment is to make a profit, right?
Many property investors accept negative gearing, as they hope their investment will grow in value and be sold for a profit in the future. Ideally the capital growth of their asset will offset the ongoing expenses/losses they incur holding the investment.
Other investors use negative gearing as a financial strategy, because it allows them to claim the costs of managing their investment property as a tax deduction.
Negative gearing may also be inevitable, because rental income alone often does not offset all the costs associated with maintaining an investment property, including servicing the interest on the loan and all the management costs.
Is negative gearing good or bad? There is no definitive answer to this as it really depends on your financial circumstances, investment strategy and attitude to risk. Negative gearing may suit one investor but not another.
For someone with a generous amount of disposable income making a loss in the short/medium term may not be a significant concern. Others may struggle to make up the monthly shortfall and find it a strain on their finances.
Now let’s look at the pros and cons of negative gearing.
Not sure if negative gearing is the right strategy for your financial goals? Like any investment decision you need to know the pros and cons so you can make an informed decision.
Let’s start with the pros of negative gearing in Australia, which include:
Investing in a property allows you to enter the market and benefit from its long term capital growth, assuming the asset appreciates in value.
Current tax laws in Australia allow you to offset the losses you incur holding an investment property against your total personal taxable income, which could be more than the total net losses.
The downsides, or cons, of negative gearing include:
There is no guarantee your investment property will appreciate in value over time. Markets fluctuate - up and down, and are subject to a myriad of local factors.
You will be making a loss from a negatively geared property, which means you need to be able to make up the shortfall between your rental income and expenses. This could put a strain on your finances, especially if your circumstances change. Real-life scenarios that could impact your ability to service your home loan include:
If you are planning on developing an investment property portfolio, having a negatively geared asset could impact your borrowing capacity with lenders. This is because it does not generate positive cash flow, which could limit your ability to service or pay back other loans.
Now let’s look at an example of negative gearing in the real world.
It’s always easier to understand a concept like negative gearing with a real-world example, so let’s look at the following scenario:
You buy a unit as an investment property for $500,000, using your savings to put a deposit of $100,000 down.
You qualify for an interest only investor loan of $400,000 from your lender.
This loan has an interest rate of 3.10% p.a., with monthly repayments of $1,033 which amounts to $12,400/year.
Your annual expenses for the property are $1,200 (maintenance + repairs), $2,500 (strata fees), $2,000 (property management fees) and $1,000 (insurance) = $6,700
Total expenses = $12,400 (home loan repayments) + $6,700 (property management expenses) = $19,100
You are able to charge $290/week in rent, which amounts to $15,080 rental income/year.
Your expenses exceed your rental income by $4,020, which means you are making a loss on your investment, and are negatively geared.
Use our home loan payment calculator as a guide to what your mortgage repayments could be a new home loan.
Australia has generous tax concessions for property investors, which means you are able to reduce your taxable income by claiming expenses you incur managing your negatively geared rental property.
To maximise your claimable rental property expenses you need to know exactly what is claimable, and what isn’t. The Australian Tax Office (ATO) stipulates what types of expenses are claimable. These generally cover anything related to the management and maintenance of your investment property when it is rented out, and include:
You can also claim for the depreciation - or general wear and tear - on your investment property, including the building (building depreciation costs) and some fixtures/fittings like carpeting (plant and equipment depreciation). The rules around depreciation rates are complex and change frequently so you may want to consult a quantity surveyor or tax accountant, who specialise in doing these calculations for investment properties.
Armed with this knowledge you should now be in a better position to decide if being negatively geared is right for your circumstances.
Have any questions about negative gearing or financing your investment property? We’re here to help. Our local team are available to chat at a time that suits your schedule.