How Does Negative Gearing Work
Anyone interested in becoming a serious property investor who is doing their research will very quickly come across the phrase ‘positive and negative gearing.’ In terms of investment in property, ‘gearing’ refers to the borrowing you take on in order to purchase your property. Thus ‘positive’ and ‘negative’ are commonly used terms which describe a particular type of investment strategy that an investor might be adopting when it comes to purchasing property. Negatively geared properties will be properties that are concentrating on future capital growth (and are therefore referred to as capital growth properties) whilst positively geared properties will be properties that provide cash flow (in the form of rental) on an ongoing basis (hence the alternative description of ‘cash flow properties.’) For a fuller description of positive gearing, click here. In this article we will be examining negative gearing in order to help you work out which type of ‘gearing’ is best for you and your investment.
What is Negative Gearing?
A property that is negatively geared is simply a property in which the total rental income that you receive per month is going to amount to less than the total combined cost of owning and running that property per month. To put it another way, a property will be negatively geared if it has an outstanding loan and the combination of both the annual interest payments on that loan and the annual expenses of the property is greater than the total annual income (from rent) that the property brings in. Negatively geared properties are properties which aim primarily for capital growth in the long term, ignoring this shortfall in the short term. They expect to recoup these yearly losses with strong capital growth and are therefore referred to as ‘capital growth properties. Though this all sounds quite ‘negative’ there are added advantages for investors to consider, such as the ability to ‘gear’ losses on the property by putting them against taxable personal income. For higher earners this can be a useful tool as the more they borrow on a property, the more interest they will need to repay and the larger their tax adjustment will be.
Working example of negative gearing at work?
Negative gearing happens when costs outweigh income which in turn creates a taxable loss to be offset against other income. The best way to understand it is to look at a classic negative gearing scenario. A good example would be an investor, let’s call him George, who owns a rental property in a capital city that brings in a total of $25,000 per year in rent. George’s total expenses and costs on his rental property, including his mortgage payments and interest, come to a grand total of $30,000 per year. What this means for George is that he has a taxable loss on that rental property of $5000 which can be offset against the tax which he has to pay on his salary from work. Any investor who is aware in advance that their investment will be making a loss over the financial year can inform the tax office and have that loss amount deducted. This process, (known as PAYG Withholding Variation) can be a great tool in adding to the personal cash flow of the investor. Simultaneously the negatively geared property will also be slowly achieving capital growth (the aim of the whole process) and which should, all being well, more than make up for the small short term shortfalls when sold years later.
The Advantages of Positive Gearing:
The Deduction of Tax Every Year
As described above, this is the most common reason for investing in negatively geared properties, particularly for high earners. Any shortfall and expenses that the property incurs are deducted from your taxable income and therefore increase your yearly cash flow.
Achieving Capital Growth
The main aim of the investment is to achieve capital growth in the long term which will more than make up for the shortfalls in rental.
Easier to Rent
Because the rental levels are much more affordable on such properties it is much easier to find tenants. This means constant occupation and constant returns.
Capital growth properties are normally found in less volatile and more consistent areas, with strong and steady growth.th.
The Disadvantages of Negative Gearing
Requires a Clear Budget in Place
Obviously your budget must allow for the shortfalls and must be able to do so for many years, to avoid falling into debt.
Much More of a Long Term Strategy Required
There will be no quick wealth creation from a property that is negatively geared. It is an investment in the future. This also means that if your circumstances change and you have to sell up early you may end up losing money on the investment.
Higher Risks Involved
That change in circumstance could be losing your job or having to pay out on some other rainy day scenario. How would you cope if that happened? If you cant keep up repayments things could go very badly very quickly.
Is Negative Gearing Too Risky for Me?
And that is the point with negatively geared properties, they are more risky. You are still, ultimately, making a loss each year. Loss making properties that have unexpected problems are much harder to cope with than profit making ones. And what happens if there is a downturn in prices and you wont be achieving the capital growth you hoped for? What if interest rates rise sharply and you have no wriggle room on the rent? You will be even more out of pocket, whereas a positively geared property investment would be able to swallow such a rise!
Property investment is not something that should be approached lightly and for negatively geared property investment that is doubly true. Certainly it is probably too risky an approach on your first property and something that you should not do without having a very long chat with a trusted mortgage broker or financial advisor.
Can I Mitigate the Risks of Negative Gearing?
Yes, there are some steps you can take to minimise the risks involved:
Ensure you choose your property wisely
In other words, do all the due diligence discussed elsewhere on this site involving costs, rental markets, location and infrastructure and strong rental demand to ensure you always have the property rented.
Have a Balanced Portfolio
The safest way to buy negatively property is as part of a balanced portfolio in which there are a number of positively geared properties capable of making up for any shortfalls.
Ensure Sufficient Income and Savings
Be aware from the start that there will be periods when there are no tenants and there are repairs and unexpected expenses. Prepare for these by putting money into a ‘rainy day fund’ specifically for that property.
Protect Yourself from Disaster
Get good insurance in other words. If you are buying a negatively geared property, insure it against the unforeseen circumstances that might arise. These days there are a number of very good insurance policies aimed directly at property investors and landlords. Get a good one!
Once again, negatively geared properties are not for everyone and it probably best not to consider one as your first property investment, rather later as part of a balanced investment portfolio. Whatever your circumstances you should never consider one without first talking to a professional mortgage broker or financial advisor who may be able to talk through all the risks involved and the potential tax and capital growth advantages to be had.