Have you heard of the term ‘negative gearing’? Probably. It’s something savvy property investors do, right? Well, kind of. If you’re interested in buying an investment property, it’s something really important to understand. But what is negative gearing exactly, and how does it affect you? Let’s take a look at negative gearing explained for every day.

What is negative gearing?

When you borrow money to buy an investment property, it’s called gearing. When the rental income you receive from the property is less than your property expenses, it’s ‘negatively’ geared. In other words, you are making a loss because the property costs you more to own than the money you are receiving in rent.

How does negative gearing work?

To work out whether your investment property will be negatively geared, it’s a simple case of comparing income versus expenses. Income is the rent you receive; expenses are all the costs you pay as the owner of the property, including things like interest repayments, rental management fees, maintenance and rates. You’re negatively gearing if your rental income doesn’t cover all of these expenses.

Benefits of negative gearing

OK, so you’ve got your head around what negative gearing is, but you’re probably wondering why on earth you’d want to be out of pocket just to own a property for someone else to live in. Well, there are a couple of reasons.

1. Expected growth – property values generally go up over time. You might be prepared to accept the loss if you expect that the capital gain you make on the property will offset this loss. In other words, the property will increase in value by more than what it costs you.
2. Tax – negative gearing can reduce your tax liability. Australia allows a deduction for rental expenses against your rental and other types of income (such as salary or business income). Therefore, where your rental expenses are higher than your rental income, the excess expenses reduce your other income, thereby reducing your income tax payable.

But at the end of the day, don’t forget that you’re still making a loss – you need to make sure you have sufficient income to fund the extra cost until the property is sold or until the investment becomes positively geared.

A negative gearing example

Let’s take a look at a negative gearing example to help make sense of the calculations.

Your mate Rod earns $70,000 a year. He’s looking at buying an investment property that’s worth $450,000. He has about $50,000 in savings so he’ll have to borrow $400,000.

Rod takes out an investment loan at 6% p.a., payable on an interest only basis. Interest on the loan is $2,000 a month. In addition to his loan repayment, he expects the property expenses will come to about $5,000 a year. All of this is tax deductible. In return, his rental income is expected to be $500 a week.

*Based on 2018/19 individual income tax rates. Excludes any offsets that may be available.

Source: Moneysmart

As you can see, Rod’s investment costs him $29,000 a year. However he receives $26,000 rental income for the property. This means the property is negatively geared. So he should be $3,000 out of pocket, right? Not quite.

Because Rod has made a $3,000 loss, he can now reduce his taxable income by that amount – from $70,000 to $67,000. This reduces his income tax payable by $1,035. When you compare what Rod’s income would have been pre-purchase to what it is with an investment property, his net income has only reduced by $1,965.

What about positive gearing?

Yep, you guessed it. If there’s negative gearing, there’s also positive gearing. And it’s just as you’d expect – the income you make from the property is greater than the loss or the costs. So the property actually makes you money from the get go.

Negative gearing vs positive gearing property: which is right for you?

There’s no simple answer – you have to look at your own financial position and your investment goals. Negative gearing can reduce the amount of tax you have to pay on your other income. By reducing your taxable income, it helps reduce the net cost of the property. It may also help you get into a property sooner, rather than saving for longer to achieve a loan amount that is positively geared. However, you do need to make sure you can cover the shortfall between your rental income and expenses.

Positive gearing, on the other hand, provides you with extra money in your pocket from the start. You might also be less concerned about the capital growth of the property, as you don’t have a loss to offset. However, the income you receive will increase your taxable income, so you will likely pay more tax.

And don’t forget to be realistic about all your costs. You may have some improvements to make on the property. Or it may remain vacant (without tenants in it) for a number of weeks. Use all tools and calculations to help you better infomed.

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