Negative gearing is an investment strategy where the overall cost of an investment property outweighs the income it generates. If this means that you invest more than you earn, is negative gearing a good thing? Why do property investors use this strategy?
Here, we unpack how the strategy works in Australia and how it can help you grow your investment portfolio.
What is negative gearing?
Properties are considered negatively geared when the rental income is less than the total cost of owning the property. This includes expenses, such as interest repayments, maintenance, repair, depreciation and other property-related fees.
Since one of the main goals of any investment is to maximise profit, making a loss through negative gearing may seem unappealing. While the name may suggest something bad, it can put you in a better financial position as an investor if used wisely.
This investment strategy heavily relies on long-term capital growth and tax deductions.
This means that investors can use negative gearing to limit the losses they incur until they decide to sell the property. Moreover, this method allows them to save on their tax by offsetting the losses made from holding the property against other sources of income, including wages.
How does negative gearing work?
If you buy an investment property and rented it out, the interest you pay to your investment loan and other fees associated with maintaining the property can be claimed in your tax return if your property is negatively geared.
Here’s an example of negative gearing: Let’s say that your property investment costs around $25,000 a year. Then, you charge your tenants around $410 a week, which is $20,160 in a year. This means that you lose $4,840 a year.
Even if you lose that $4,840, you can claim this amount against your taxable income and reduce your overall tax.
Resident tax rates 2021–2022
|Taxable income||Tax on this income|
|0 – $18,200||Nil|
|$18,201 – $45,000||19 cents for each $1 over $18,200|
|$45,001 – $120,000||$5,092 plus 32.5 cents for each $1 over $45,000|
|$120,001 – $180,000||$29,467 plus 37 cents for each $1 over $120,000|
|$180,001 and over||$51,667 plus 45 cents for each $1 over $180,000|
Source: Australian Taxation Office (ATO)
Taking the example above, let’s assume that your taxable income per year is $120,000, and your estimated tax is $29,467. If you claim a rental income loss of $4,840, this means your taxable income goes down to $115,160. Based on the ATO tax rates for 2021–22, this brings down the tax you pay to approximately $27,894.
How to calculate negative gearing?
To give you an idea about how much you’ll save through this approach, you can consider these steps to help you calculate and invest smarter:
Step 1: Calculate your rental income for the year. This includes the rent that your tenants pay you.
Step 2: Calculate your investment costs, which include the interest repayments, any repair expenses, insurance, council rates, other property management fees and depreciation.
Step 3: Subtract the investment income from your investment costs to know how much loss you make a year.
While these steps can help you estimate how much you negatively gear, it’s best to use a negative gearing calculator and consult with the ATO or your accountant to make sure you get the figures right.
What are the benefits and risks of negative gearing?
Property investing comes with advantages and disadvantages. Here are some of the main benefits and risks associated with negative gearing:
Why would you invest in an asset that makes losses every year? One of the main advantages of negative gearing is offsetting the loss against other incomes. This reduces your tax liability by deducting your rental loss from your taxable income. Aside from the rental loss, you can also claim deductions on maintenance fees and furniture depreciation.
With the amount you save on the tax you pay, this is a great source of cash flow as you wait for your property to increase in value. This makes negative gearing highly beneficial, especially to investors with high incomes.
Aside from claiming tax deductions, there’s also the possibility of capital gain. Negative gearing can be an appealing investment despite the lack of rental yield because you can gain a huge profit if your property increases in value.
Holding on to your property investment until it grows in value allows you to sell it at a higher price and achieve capital gain. For example, you purchased a property in 2018 at $900,000 and sold it in 2021 when its market value went up to $1.3 million. This means you earned $300,000.
Owning an investment property and becoming a landlord is costly. Aside from the interest repayments, you also need to factor in other expenses, such as maintenance costs, council and water rates and repair costs.
If your property is negatively geared, this means you may need to shoulder the additional fees that your rental income cannot cover. You might consider the hidden costs of buying a home in Australia.
Moreover, there’s also the possibility of not having tenants. The rental market is susceptible to changes, so there may be a time when your property sits empty. This leaves you without rental income, so you need to pay all the investment costs on your own.
The property market is highly competitive, so there’s no guarantee that your property will increase in value. If your rental property decreases in market value, you may lose more than you gain from the tax deductions.
Positive gearing vs negative gearing
Unlike its counterpart, positive gearing occurs when your rental income is higher compared to your investment costs, which gives you positive cash flow. This means that a positively geared property earns you an annual profit.
Here’s an example to help you have a clearer idea of how positive gearing is different from negative gearing. Let’s say that it costs you around $400 a week to own your investment property, and you charge $320 per week in rent. This gives you a weekly rental income of $80, which is $4,160 annually.
The passive income from your positively geared property can be a great source of cash flow and gives you the confidence to meet your loan repayments.
Who benefits from negative gearing?
With the risks associated with it, this investment strategy is not fit for all investors. To greatly benefit from negatively geared properties, you should:
- Have a reliable source of income: Since your property costs more than it generates, you may need to shoulder some of the expenses in maintaining your investment. You should have a stable source of cash flow to help you with that.
- Have a high income: Negative gearing works best for property investors who have higher salaries because of tax savings from the net loss. Moreover, having a high income can help you bear the losses.
- Have knowledge or expert support in the property market: With the danger of capital loss, you should have adequate knowledge about the market. This ensures that you carefully choose the right property, get the most out of your investment and achieve capital gain when you decide to sell it. To help you, you can get your FREE property report instantly.
Which is better: Negative gearing or positive gearing?
Choosing between the two options depends on your financial situation, goals and investment property.
You can choose to have a negatively geared investment if you can cover the losses out of your pockets and gain more from the tax benefits. For negative gearing to work in your favour, you should calculate your annual salary, rental income, outgoing costs and taxable income to ensure that you’re not losing more from your investment.
On the other hand, you may choose positive gearing if your priority is cash flow, and you are willing to pay capital gains tax. Positive gearing is especially beneficial to investors who are in the lower tax bracket and are looking to generate rental income. This gives you comfort knowing you have a passive income and enables you to build a buffer in case your financial situation takes a hit.
Is negative gearing worth it?
Whether this strategy is right for you or not depends on your financial circumstance and goals. If you have a reliable cash flow, and there’s a great chance that your property may increase in value, negative gearing can be worth the shot.
But before deciding between positive gearing and negative gearing, it’s best to consult with a financial adviser or tax agent. This way, you reap more benefits from the strategy you choose and achieve the lifestyle you want while minimising the risks of your investment.
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