With more investors in the property market than ever before in Australian history, real estate has become ‘the’ subject to talk about. It’s now a national sport. Everyone these days loves to talk real estate jargon and the term negative gearing is one of the more popular terms that gets thrown around. The truth is negative gearing is now part of the fabric of the property market in Australia - but what is it?
Investments can be negatively, neutrally or positively geared. The relationship between total costs of owning the investment and the income the investment generates, dictates whether the investment is either negatively, neutrally or positively geared.
Let’s break it down and take a closer look at gearing strategies used in investment:
Gearing simply means borrowing money to invest in an asset. In terms of property, gearing means that you have taken out a loan to purchase a property.
Negative gearing is when the interest payments and other investment costs are higher than the income generated by the investment. That is, you are making a loss. The upside of making a loss on an investment property is that you may deduct that loss from your taxable income, thereby reducing the overall tax you pay on your other income.
Neutral gearing is when interest payments and other investment costs are equal to income generated by the investment. You can claim a tax deduction for the interest and investment costs against your investment income, however as you are neither making a profit or a loss off your investment property, neutral gearing will not affect the overall income tax you pay.
Positive gearing is when income generated by the investment property is higher than interest payments and other investment costs. That is, you are making a profit. Accordingly, this profit will increase the overall income tax you pay.
For many people, making a loss on a negatively geared investment property is a sound investment strategy. How so?
Nobody enters the property investment game to lose money though the reality is that most buyers do borrow a large portion of the property’s purchase price. For the majority of Australians, we will purchase property that is negatively geared. i.e. the rental income will not be as much as the interest repayments. In Australia’s booming property market, the prize is the capital growth achieved over time as the property’s value increases, and the benefits of getting into the market sooner generally far outweigh waiting and saving in the hope of reducing interest costs. Let’s look at the example below to further illustrate this point. For simplicity, let’s just focus on the interest repayments (but note there are other costs and expenses that go with owning an investment property!).
Let’s imagine that you have purchased an investment property for $880,000. You have your 10% deposit in the bank and you have a loan for the remaining $800,000 with an interest rate 7% p.a. The interest payable on the loan is $56,000 annually.
Imagine now that the investment property is generating income of $550 per week in rent totalling an annual rental income of $28,600.
Looking at the example above you are paying $56,000 in interest repayments but the investment is only earning $28,600 in rental income which means you will be out of pocket $27,400 per year. That’s the downside.
The upside is the capital growth over time. From the moment you purchase your property it should be going up in value and as time goes on the property’s value will continue to climb. Hopefully your rental income will also rise over time.
Continuing the exercise, if your investment increased its capital value by 10% in the first year of ownership (which is not uncommon in the current market), this equates to an increase of $80,000 equity you have in the property.
It’s now the end of our first year, and you have had to pay out of your own pocket $27,400 in interest repayments. However over the year the property’s value has increased by $80,000. The end result – you are now $52,600 richer then you were 12 months ago.
In addition, you are able to reduce your current assessable income (eg. the salary you receive from your day job + rental payments) by the $27,400 you paid in interest, which will lower the total tax you pay.
Ideally it would be great to have a property that is neutral or even positively geared and still make a net profit but the reality is in a market dominated by negatively geared properties these sorts of properties are becoming harder and harder to find if you are planning to borrow most of the purchase price. When borrowing money to invest remember that there are risks and you need to be confident in your ability to make the minimum repayments to the Bank when the property is not leased and pay for upkeep. However, borrowing to buy a negatively geared property gives you the ability to get a piece of the vibrant property market and help you build wealth faster.
When examining your own cash flow position under the microscope, be sure to include any tax return income and all associated expenses in relation to owning the property and to take advantage of all available deductions from you taxable income.
In the end, it comes down to this – Negative gearing will work for you if the money you make from capital growth is higher than the money you lose from expenses and rental shortfall.
Please note the information provided in the above article is intended for general use only. If considering a gearing strategy seek financial advice to fully comprehend the potential risks and return involved.