Understanding how and why negative gearing works is essential before investors jump into this tax-efficient but complex strategy.
Negative gearing is a popular investment strategy and done correctly it can result in a great financial benefit for property investors.
What is negative gearing?
Put simply, negative gearing involves running an investment property at a loss – so the annual outgoings exceed the rental income generated.
Buyers incur costs in purchasing, owning and running an investment property. By far the biggest cost is generally the interest payable on the loan. Other costs can include bank fees and charges, maintenance and repairs, letting agent fees and so forth.
Basically, a property is negatively geared when the costs of owning the property exceed the income it produces. When a property is run at a loss, under Australian tax laws buyers can claim a tax deduction which can be offset against their personal income.
Why do it?
In some cases negative gearing is unavoidable for investors. The higher the percentage of the value of the property the buyer needs to borrow, the lower the rental income – and this can often mean a loss. But some investors – particularly those in higher tax brackets – deliberately look to negatively gear their property specifically for the tax incentives.
Let’s look at an example. Say an investment property generated rental income of $2,000 per month. In addition to income, the owner has to pay expenses, such as loan interest and property maintenance ($2,500 a month), and council rates ($100 a month). This leaves the owner with a shortfall of $600 at the end of the month. With negative gearing, that $600 loss (equating to $7,200 per annum) may be claimed as a tax deduction.
When to avoid it?
Negative gearing is not a risk-free investment strategy. Investors are often happy to make a short term loss on their property as long as the value of the property is rising as they offset any losses against tax deductions and the eventual capital gain.
But a property that is negatively geared in a flat market could make an overall loss for the investor as the tax incentives don’t fully cover the overall shortfall in monthly cash flow.
Things to remember
Negative gearing is not the only investment strategy available. Positive gearing, while less tax efficient, does mean that there is some income generated on the investment property.
Whatever your strategy, it’s important to speak to your tax accountant and other related professionals before making a commitment to ensure that you’re in the best position to achieve your objectives.