Negative gearing is a strategy some investors use to reduce the amount of tax they pay on their primary income. It can save you a lot of money, but there are some pitfalls you need to look out for.
How does negative gearing work, and should it be something you consider with your investment properties? Understanding what it is and how it can work both for you and against you is the purpose of this article.
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What is negative gearing?
Negative gearing is a financial strategy where a person buys an investment property with an expectation that the rental income it generates will be less than the expenses involved in owning and maintaining it.
Or, to put it more simply, negative gearing occurs when an investor is making a loss on their rental property.
The investor can offset this loss against their taxable income, reducing their overall tax liability, so they pay less tax. The ATO has some more information regarding this.
Residential properties, such as homes, units, and apartments, are most commonly used for negative gearing. While you can negatively gear commercial property, this is less common, as they are mostly set up for positive gearing.
How does negative gearing work?
- Investment property An individual purchases a property with the help of an investment loan or a home loan with the intent to rent out the property.
- Rent The rental income is considered the primary income for this property.
- Deductions Expenses related to the investment property such as interest payments, maintenance and repairs, insurance, property management fees, can all be deducted from the rental income.
- Negative cash flow If the total deductions are more than what is earned from the rental income, this is considered a negative cash flow.
- Tax benefits The negative cash flow can be used to offset the investor’s taxable income. This can reduce their overall taxable income, lowering the amount of tax they owe.
Here is a simple look at how negative gearing can work.
Let’s say you owned an investment property with a mortgage repayment of $650 per week. Whilst the full repayment is not tax deductible, the interest component, which is $550 in this example, is tax deductable.
Other examples of negative gearing in this instance could include spending another $200 on council rates, body corporate fees, water, insurance and repairs.
In total, you are spending $750 per week on your investment property.
Now, let’s suppose you charge $600 per week for rent.
This being the case, your total income from your rental property is:
Rent ($600) - expenses ($750) = -$150.
Your investment property is negatively geared for $150, hence you can claim $150 per week against your income tax.
This is a general example, of course. Not all items are deductible and the actual negatively geared amount could be different. Check your deductibles every financial year to update and determine your actual negatively geared amount.
What are the benefits of negative gearing?
There are advantages to negatively gearing your investment properties such as:
- Reducing Tax By claiming the losses of your rental income as a tax deduction, you can reduce your taxable income, and hence pay less tax, saving you money.
- Long term gains Over the long term, the value of the investment property may increase. This is called capital appreciation.
- Leverage An investor can use their investment as leverage to scale up to more expensive assets and build their portfolio. You may need to investigate refinance options to do so.
What are the risks associated with negative gearing?
While a negative gearing strategy sounds great, saving you tax and giving you something that may gain capital appreciation over time, there can be risks involved. These include:
- Cash flow shortfall By gearing your rental income to be less than the costs of the investment property, you will have a negative cash flow. You need to have enough income elsewhere to cover this until you can benefit from the tax savings. This “saving” is only the tax deduction benefits based off your marginal tax rate. You won’t get the “full loss” back as savings.
- Interest rate rises If interest rates rise, your loan repayments on the investment property will go up, increasing the cash short fall. Check with our interest rate updates page to see if you can afford your negative gearing or not.
- Rental demand If the demand for rentals falls, or you cannot find a tenant for your investment property, then you will be maintaining empty premises, which can be costly.
- Changes in tax law There could be changes to negative gearing in tax laws implemented that can disadvantage investors. The Australian Tax Office (ATO) has a comprehensive and up-to-date page regarding all rental expenses, including negative gearing.
Should I consider negative gearing my investment property?
This is a conversation you need to have with your financial advisor. They can walk you through the ups and downs of negative gearing, and check to see if you can afford it now, and for the long term.
Given that this is a long-term strategy to save you money and to take advantage of capital gains, consider how long you would be investing for.
Have a feel for the market. Are interest rates going to go up, increasing the financial costs you must bear? Are tax laws going to change and impact negative gearing?
There are always other options for you to invest in. You could, for example, look at positively gearing your investment to make money from your rental income.
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