Positive gearing vs Negative gearing

 

Nothing polarizes property investors more than the conversation involving positive gearing and negative gearing. Hence, here are the differences and their pros and cons.

Understanding what positive and negative gearing means, as well as their pros and cons, is an important part of a property investor’s career. Determining the difference between the two and acknowledging their influence on investment profits will determine how financially successful an investor can become.

Hence, here is more on positive gearing and negative gearing, from their drawbacks, benefits, and risks.

In simple terms, negative gearing is where expenses on an investment property exceed more than the tenant’s income. Therefore, the investor will spend more on the property than they profit from it.

These expenses include things such as insurance, real estate agent fees, financial adviser costs, home loan, council rates, and additional bills.

Although this strategy seems as though investors would lose money, it can be a savvy way to reduce the tax paid.

The net loss that occurs during the negative gearing strategy can be used against the investor’s total taxable income for the year. This means that the amount that is lost can be used against the amount they received, which will reduce the total amount of tax payable.

An example of this would be if a property has a rental income of $100,000 but, the total expenses paid by the investor consisted of $120,000. Hence, there is a net loss of $20,000.

The investment property net loss of $20,000 could then be used against tax payable, which means that the investor’s tax bill can use the net loss against their incomings for the year. Hence, a tax deduction can provide tax benefits and in a sense, tax savings.

Information about negative gearing

When an investor uses the negatively geared property strategy, on purpose or not, the amount that they lose is the amount they can deduct from their total income for the year. Hence, they will pay a lower amount of tax by reducing their total earnings with their net loss.

Property expenses

In negative gearing, property expenses cost more than the tenant’s income and payments. Hence, the investor will always experience a loss of profits.

Property expenses can include council tax rates, estate agent fees, property maintenance, land tax, repairs, water rates, insurance premiums, and any other cost associated with the property investment.

Borrowing costs

A negatively geared property involves borrowing costs too, which involve any money borrowed by the lender. This can include interest payments and other loan fees.

Depreciation

The depreciation of a property structure involves the tax deduction, which often occurs over time. This involves the depreciation of a building due to its structure. Newer buildings typically involve depreciation costs that involve fittings too. Hence, some investors prefer new buildings so that they can use the fittings in the depreciation as well as the decline in value of the structure. Newer buildings typically have more depreciation to write off.

In comparison, positively geared properties involve a positive cash flow, whereby earnings from the property are higher than the expenses. Therefore, the investor will attain a profit.

For most investors, positive gearing is seen as a much lower risk. This is due to cash flow positive properties generating more profits. The returns of property investments are more likely and consistent.

This profit for investors will help them in the event of an increase in mortgage repayments, higher interest rate hikes from home loans, and unexpected property costs.

It is important to note that a positively geared investment cannot be guaranteed. It all depends on the rental return, the size of the loan advised by a financial adviser, and market conditions. Should the rental market see a decline in sales, prices may lower, and therefore, a positive cash flow might be harder to attain.

With a positively geared property, the tax benefits are not so great when it comes to tax savings as there are no tax deductions to be made. This is due to a positively geared investment offering capital gains and more profit.

To compare a positively geared property investment to a negatively geared property investment in simple terms, one generates a positive cash flow and the other offers tax benefits.

Negatively geared investments have pros and cons, just like positively geared investments do.

Benefits
  • – Saving tax. Negatively geared properties will involve tax-saving benefits as the depreciation and exceedance in expenses can be claimed against total earnings. Hence, when tax time arrives, investors can reduce their taxable income.
  • – Capital growth. Should you sell your property at the right time in its property cycle, then you will likely attain a great profit and therefore, not be hit so hard with the loss of net income over the years of investing in a negatively geared property.
  • – Longer tenants. Negatively geared investments and properties can often attract longer-term tenants, due to strong rental demand for lower rent homes.
Drawbacks
  • – Less cash flow. When an investor puts their money into negatively geared investments, the cash flow might be much tighter. It will be okay so long as the investor has another income stream, which could cover losses. However, it could be an issue if the cash flow becomes so tight that it forces the investor to sell and therefore, not benefit from the capital growth opportunity.
  • – Reduced borrowing opportunities. A lower income can significantly affect your opportunity and ease to borrow home loans.
  • – You will still get taxed. As a negatively geared investor, you will still be taxed. This will be on your capital gains, where the investor will pay tax for 50% of their capital gains.

Likewise, there are pros and cons to positive gearing to know about, which could offer more borrowing power yet slow growth. Here’s more.

Benefits
  • – More cash. The main benefit of positive gearing is that investors will earn more cash, which can be used as a deposit for other properties or other investments. An investor will find positively geared property opportunities much more beneficial in terms of profit and financial freedom.
  • – Financial buffer. Should an investor need extra money to cover unexpected maintenance or your own home costs.
  • – Ideal for all investors. Seeing as positive gearing properties offers a higher chance of profit, those who are new or established in investing will enjoy the more positive cash flow and lack of debt.
  • – Great for your portfolio. Having a higher return in profit and minimal losses, a positive gearing home will look much better on a portfolio.
Drawbacks
  • – Slower growth rates. The main drawback with positive gearing is the slower growth. Seeing as rental fees might be higher, as will expenses, there will be a reduced profit margin.
  • – You will pay more tax. The tax savings are non-existent if a property attains a positive cash flow. Hence, you will pay more tax as you will have no losses to claim for.
  • – Fluctuation in rental prices. Seeing as the rental market is changing all the time, positively geared investors will likely see a fluctuation in growth and profits.
  • – Unexpected costs. There will be unexpected costs from time to time with rental properties. It could be paying extra for a financial adviser for a new property or additional maintenance fees. Either way, an investor can never be prepared for unexpected costs.

A huge benefit of depreciation for negatively geared properties is that tax deductions can be made for depreciating properties. This means that negatively geared investors can increase the cash loss on paper without actually experiencing it in their pockets.

The depreciation of a rental property is natural and unpreventable. This could include structural issues or fittings for newer properties.

An example of how depreciation and negative gearing go hand-in-hand is:

  • – A taxable income of $100,000
  • – Expenses of $10,000
  • – Depreciation of $10,000
  • – Equates to $80,000 of new taxable income and tax savings

A lot of investors will own their own home as well as other properties, which they rent out to tenants. Hence, these particular investors will aim to get the most out of their own home loans as well as their investment properties.

The two go hand-in-hand when trying to maximize taxable deductions as it will reduce the amount of tax that will need to be paid when tax time comes around.

Investors utilize the negative gearing strategy by:

  • – Using an interest-only loan. When an investor uses an interest-only loan, the main purpose is so that the interest that is charged is much higher. This means that profits are less likely and therefore, will help the investor remain within the negative gearing barrier.
  • – Excess cash to be used against personal homes. If an investor experiences a positive cash flow due to the rental property market prices fluctuating, an investor can return back to the negatively geared strategy by using the excess cash on their own home loan. Hence, the higher interest made through investing can be used to reduce tax.
  • – Setting up borrowing loans that accumulate debt. Some investors will take it to the level of encouraging debt, which is in order to remain within the tax savings barrier. A borrowing loan might incur high interest and therefore, be vulnerable to debt.

Overall, an investor that wishes to invest in negative gearing will use a strategy to ensure that their tax loss occurs each year so that they can reduce their taxable amount.

It is important to discuss the role of interest rates and how they can impact negative gearing to understand how to avoid an extreme tightening of cash flow. Although negatively geared investors are more vulnerable to financial loss, it is essential to not go into debt and have to sell a property before gaining from the capital growth.

Hence, a negatively geared investor must ensure that they could still afford rental payments and mortgage repayments if the interest rates rise. Hence, if the investor invests when interest is low, then they must forecast how much they can afford should interest increase, so that they can avoid potential money struggles.

At the end of the day, the overall goal of an investor is to attain a profit. Whether that be through a positive cash flow or paying less tax.

For negative gearing, it is essential that the investor understands what they can afford. Although they will enjoy tax savings, they will still be at a loss. Hence, it is necessary to plan investment strategies and ensure to avoid debt and potentially being forced to sell a property before its value increases. Should an investor miss out on capital gains, then they might experience an overall financial loss.

Should a negatively geared investor manage to sell a property after capital gains occur on the property, then they might be able to make back their lost money (or more if the property value increases tremendously).

When an investor is understanding of their finances and confident in the growth of capital gains, then they might be much more at ease when investing in a negatively geared property. Their hope is that the capital gains will payback for the money lost over the years through higher expenses than rental payments from tenants.

It is quite clear that negative gearing poses a lot more risks than positive gearing, due to the loss of profit due to higher expenses. Although no investment is risk-free, negative gearing poses more risks than positive cash flow investments. Therefore, it is essential to acknowledge the risks.

Negative gearing can help to reduce a tax bill but, there is still an opportunity to lose a lot more money than expected. Should an investor know what they are doing, then they might be able to attain a huge and comfortable profit when selling the property after capital gains have increased the value of the property.

However, until then, there are many risks:

  • – Tenancy fluctuations. From time to time, rental properties might see a dip in interest. Hence, rents prices might need to reduce to attract tenants, which will create a bigger gap between income and expenses. Or, the property might be vacant and therefore, the investor will receive no income from the property at all. Tenancy fluctuations are unpredictable.
  • – Sudden job loss. If an investor has a job alongside their investments, which is wise if they are at a loss, then a sudden job loss could significantly impact their ability to pay back their loan.
  • – Expensive emergency repairs. An investor will not be able to predict when a property might need emergency repairs. Nor can the investor forecast the costs of repairs. Hence, expensive emergency repairs could significantly impact their savings buffer and financial stability.
  • – Lack of ability to recoup investment losses in some properties. Some properties might unpredictably reduce in profit or not grow in value as expected. Hence, the negatively geared investor could lose the ability to recoup their investment losses.

Due to the vulnerability and potential risks of negatively geared investments, it is essential for investors to do their research of the property prices, areas, and more before deciding to invest and take the plunge with negative cash flow properties.

Likewise, it is essential to have a job alongside the investment or a savings buffer in case of emergency payments or issues.

With it being clear that positive gearing can offer profits and a positive cash flow, it is understandable that positive gearing can be suitable for any investor.

However, not everyone can benefit or be comfortable with negative gearing. Hence, here’s a closer look at who can actually benefit from negative cash flow when negative gearing occurs.

  • – Investors looking for long-term income. When an investor is looking for long-term income, negatively geared properties can be a good option. They will attract tenants due to the lower rent fees and therefore, provide a long-term income – as long as the property attains a regular income from tenants. Likewise, it can reduce taxable income, which can help people feel more comfortable when paying taxes.
  • – Investors seeking capital gains. If an investor is comfortable with losing money through negatively geared properties, then they may benefit from capital gains. The capital gains from a property after a few years of making a loss might help the investor recoup their money.

To summarize, there are pros and cons of both positive gearing and negative gearing. The latter is suitable for those who are established and understanding of the property market and those who have a savings buffer.

Furthemore, positive gearing is ideal for any type of investor, new or old. It will create a positive cash flow and a create a more stable income, which is great for property and investment portfolios.

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