Negative gearing is one of those terms you may understand 90% of, but if someone asked you to explain it, you’d be left running a quick Google search. Sure, we get it in concept - but what is negative gearing in reality, and how can you put it to work?
Negative gearing occurs when people borrow money to invest in an asset, most commonly a property, and the resulting income from that investment equates to less than the asset’s expenses. This results in a loss. For some people, negative gearing immediately gets confusing - isn’t the point of an investment to make money, not to lose it?
We can thank Australian tax law for why negative gearing is a popular investment strategy for many Australians. It allows investors to deduct losses they make on investment properties from their taxable income, one of the major attractions for those entering the property investment market. This, in turn, can lead to an increase in rental housing supply. The ongoing impact is an overall benefit within markets currently marked by their scarce rental supply.
Given the notoriety of this policy and how many Australian investors it impacts, it’s no surprise this is an area of government policy that's closely scrutinised. Changes to negative gearing policies have a flow on effect across the amount of housing available and the rate of rent an average family is paying every week.
Short-term losses, long-term capital growth
Perhaps surprisingly, many investors who rent to tenants aren’t looking for a positive return on their investment weekly. Instead, their strategy is based on the concept of that property experiencing long-term capital growth, with its value increasing incrementally year-on-year until a profit can be made from a future sale. In the meantime, savvy investors can make the most of negative gearing to minimise their tax payable. They can bide their time until it’s the right moment in the market to sell their investment property.
Neutral gearing
While negative gearing is the term most commonly discussed in the wider market, neutral gearing is another strategy used by investors to build their long-term portfolio. Neutral gearing is an approach where money borrowed to invest into an asset equals the income the property makes. This allows you to break even on your investment. You’re therefore not deducting any losses from your taxable income. However, it can also be a helpful strategy for investors who need to watch their monthly cash flow position while still looking for a long-term growth outcome.
Positive gearing
On the other end of the spectrum from negative gearing is positive gearing. This occurs when the expenses on money borrowed to invest in an asset are less than the income made from that investment. Some investors prefer to see a consistent return week to week. They're generating an income from their investment properties, while also building towards a capital gain from a future sale if the property’s value increases.
As the investment generates a positive return, no deductions apply to taxable incomes. The income generated by the property will also be subject to income tax at the corresponding marginal tax rate. This strategy requires careful tax planning to ensure there’s no ugly surprises at the end of the financial year.
Some investors may choose to use a surplus income to whittle away at the size of the corresponding loan, or to fold that income into their monthly take-home. Positive gearing can be a powerful option for investors, but finding properties that can offer a return can be a challenge once all expenses are considered (such as rates, insurances, property management fees and maintenance costs). Properties that offer positive returns are in high demand across a competitive investment field.
The role of capital growth
For investors using negative gearing in their investment approach, capital growth is paramount in seeing a long-term return against their ongoing investment. If property prices were to grow by 10% pa, year on year, and an investor held a property for a decade, they’d stand to see a 100% increase on their potential sale price at that point against their original purchase price. Even with expenses deducted, this can present an attractive return for investors oriented towards the long-term.
Investors utilising negative gearing know to focus on their net worth as a marker of ongoing investment success, rather than the simple equation of money in vs. money out.
Ingredients for negative gearing to work successfully
Negative gearing allows a wider proportion of the population to purchase an investment property sooner than if they’re only reliant on positive gearing. This is beneficial for rental prices, helping to control rising rental rates by increasing the availability of rental housing.
Negative gearing is successful when investors can access a reliable cash flow that will meet their pre-tax borrowing costs. They also need to earn enough income on an ongoing basis for their loan repayments. It’s also a strategy that is effective for those who can hold onto the property for the time necessary for its value to increase to profit. For investors who don’t see a long-term capacity to sit on their investment, negative gearing could result in a loss, mainly when stamp duty, transfer fees, legal fees and ongoing property management expenses are accounted for.
How to decide on the investment strategy for you
There’s no one-size-fits-all approach to a wise financial investment. This is why it’s so important to utilise the advice available to you from the experts - in this case, consulting with a financial advisor can be of great benefit in identifying the investment strategy that’s the best fit for your particular needs and capacities.
Purchasing a property is one investment that can have an impact for a lifetime. By understanding the options available to you, you can make the most of your investment opportunities.