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How Does Negative Gearing Work and What Are the Benefits

Beautiful Sydney neighbourhood with several investment properties that are available for rent

Negative gearing is a popular investment strategy in Australia. Gearing means borrowing money to invest – strategies include positive and negative gearing. Using finance to pay for your investment property builds up your expenses. Investors need to ensure they have enough cash flow to repay interest, plus other costs, like insurance and ongoing maintenance.

Some investors turn to negative gearing to offset these expenses. If you’re interested in negatively gearing your property, follow this article to learn how it works, the pros and cons, and how to minimise the risks.

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What is Negative Gearing?

When an investor makes a loss on their rental property, they can deduct the net rental loss on their tax return. A highly common technique, 68% of property investors report a loss on the rental income earned.

This loss occurs when the expenses of repaying the home loan interest, managing property maintenance and other property-related costs are not met by the rental income. Investors who want to negatively gear tend to intentionally set lower rental prices. Therefore, negative gearing is often seen as good for the rental market as it keeps rent prices down.

Making a loss on a rental property might go against the grain. However, the expectation is that the capital gain at the point of selling will offset the loss. Generally speaking, negatively geared properties appreciate in value over time. Some property investors, however, might find themselves unintentionally negative gearing if their expenses unexpectedly outweigh returns.

Also, when a property is sold, only 50% of the appreciation value is subject to income tax (as long as the property has been owned for more than twelve months).

It can also be done with other investments, such as investment shares.

How Does Negative Gearing Work?

The tax system in Australia works on the basis that everyone pays tax on their personal income, less any deductions in making that income. Just how businesses can deduct expenses from their taxable income, property investors are eligible to do the same.

Let’s look at an example to see how negative gearing works in practice. If you were to buy an investment property for $600,000 with an interest rate of 4.5% over a term of 25 years, you would have to pay a total of $400,499 in interest. In your first year, you pay $24,482.17 interest. On top of that, your rental expenses (such as maintenance, repairs, insurance, etc.) equal $3,000 for the year.

The total property expenses are $27,482.17. You charge $500 weekly rent; your year’s rental return is $26,000. In your first year, you have made a loss of $1,482.17.

You can then deduct this loss from your taxable income. Plus, over time, the property value should appreciate, meaning that you will make your money back when you sell.

What Are the Benefits of Negative Gearing?

With such a large proportion of property investors negatively gearing, the benefits must be pretty good to risk making a loss. Let’s run through what they are.

Reduction in taxable income

As we saw earlier, the reduction in taxable income is a huge draw to property investors. By lowering your rental prices, you could make a more significant loss but higher tax benefits. Plus, your rental property would be more competitive on the market.

Long term gain

Property values fluctuate regularly, although they are generally considered to increase over time. The same is, subsequently, true of rental prices. With negative gearing, you are able to afford a property that is likely to increase in value.

Either you can sell the property when the profit outweighs the previous loss, or you can take advantage of future higher rental prices. The long-term capital gain should offset the short-term rental loss

What Are the Risks of Negative Gearing?

However, with the benefits, there are downfalls and risks to consider. Remember, despite the tax benefits and long-term gains, a negatively geared property still makes a loss. It is crucial to think about what this loss means for you in the short term.

Consider the following:

  1. What will you do if your rental property is left vacant for some time?
  2. What if property values decrease dramatically or your property investment does not appreciate over time?
  3. What if interest rates on your home loan rise quickly, and your agreed rental price with the tenants creates a far more significant loss than you bargained on?

Ensure you take the time to consider what you would do or how you would cope if you found yourself in any of the above scenarios. Do you have other income sources that you can rely on should you find that negative gearing doesn’t work for you?

That said, there are ways to minimise the risks of investment property negative gearing, which we’ll get to later.

What is Positive Gearing?

Positive gearing is the very opposite of negative gearing. A positively geared property makes a profit on its rental income. The returns equal enough income to cover the costs of interest expenses and other property fees. Perhaps the more traditional strategy, positive gearing is what most of us think of when we consider getting into the real estate market.

What Are the Pros and Cons of Positive Gearing?

The main benefit of a positively geared house is that you get to keep the profit for yourself. You can put it in savings, invest it in shares, diversify your property portfolio or use it for whatever you may choose. Plus, knowing that your rental returns are enough to make the loan repayments, your financial situation will be more confident.

Therefore, you are likely to be better positioned to borrow money for other investments as your borrowing power will be stronger. Similarly, positive gearing is also a more suitable choice for those nearing retirement as they don’t want to be saddled with debt.

However, you will have to pay a higher tax bill with positive gearing. Also, there is the possibility that your capital growth might rise at a slower rate.

A savvy property investor might have both a positively geared and negative gearing strategy within their property portfolio.

How Much Can I Save On Taxes with Negative Gearing?

The amount you save on your tax return depends on your circumstances. However, it could easily be a few thousand dollars a year. Ensure you seek help from a financial advisor or tax specialist to understand how you can take full advantage of your negatively geared investment property.

What Can I Deduct from Tax?

You can claim your losses as a tax deduction. Although, you can only claim for expenses that are directly related to producing an income on your property. These tax deductions can include:

  1. The interest repayments on your home loan
  2. Marketing or advertising fees for tenants
  3. Body corporate fees and charges (for units)
  4. Council rates
  5. Water charges
  6. Land tax
  7. Cleaning and property maintenance
  8. Repairs
  9. Gardening and lawn mowing
  10. Pest control
  11. Insurance (such as building, contents, public liability)
  12. Property manager’s fees and commission
  13. Income protection insurance
  14. Legal expenses

Is Negatively Geared Investment Property Right for You?

So, is negative gearing the right decision for your investment properties? It is imperative that you take into consideration your personal circumstances and financial situation. Property investing is a challenging enough venture. Are you up to the risks of negative gearing?

As with all financial decisions, your strategy should be aligned to your individual risk preferences. Conduct original research and talk to an expert about your investment if you are serious about negative gearing. A mortgage broker will help you through the entire process of your investment loan application and help you identify the risks of negative gearing.

How To Minimise the Risks of Negative Gearing

If you’re still interested in negatively gearing your investment properties, here are some things you can do to minimise the risks.

Invest wisely

Shop around extensively for your investment. A property located near convenient amenities and appeals to a wide range of tenants should prevent it from being vacant for long. Plus, look for property that is likely to go up in value significantly over the next ten, twenty or thirty years. Remember, negative gearing is a long-term investment.

Manage your income

Do you know the overall costs of owning a property? There are moments when it will cost you a lot of money, e.g., if the property is vacant or if it needs significant repairs. Therefore, it is worth considering if you will be able to successfully manage all the costs that come with purchasing and owning real estate.

Protect yourself and your investment

Not only do you need to insure and protect your latest asset, but also yourself should any unexpected circumstance hit. It would be best if you always had a plan for the worst-case scenario.

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Key Takeaways

Making a loss on your rental property to offset against other income is a brave, risky and often rewarding strategy. Many property investors consider it the ultimate way to generate long term capital gains. Many others have both positive and negatively geared properties in their portfolio.

However, before embarking on this investment venture, consider whether you are prepared for the risks. Do your research and speak to an expert financial advisor or mortgage broker if you believe this is the path for you.

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