Negative and positive gearing explained
Understand what negative and positive gearing is all about
If you have ever looked into investment property, you’ve very likely heard the term ‘gearing’ before. If you’re confused, the good news is that in property terms, gearing is actually quite simple to understand. Once you’ve got your head around it though, the question of whether positive or negative gearing is preferable isn’t quite as straightforward. The right investment decision for any property investor will depend on their individual financial circumstances. We’ve broken down both positive and negative gearing here, made the case for and against for both to give you a fighting chance of making the best decision for your situation.
What does gearing mean?
In simple terms, gearing is basically a term for borrowing money to invest. In business, gearing refers to the extent to which a company’s operations are funded by borrowed money versus shareholder equity, measuring the companies leverage. In property terms, gearing refers to the relationship between how much an investment property is costing each month and how much revenue it is generating.
What is positive gearing?
In property, positive gearing simply means that the rental income you generate from your investment property is more than the amount you are spending on it each month in loan repayments, maintenance costs, renovations, etc. If your investment property earns $20,000 a year from rent, and your expenses (loan repayments, body corporate fees, maintenance, etc.) are only $15,000, you have a positive annual cash flow of $5,000. In simple terms, a positively geared property just means one that is generating profit for the property owner. As you might expect, positive gearing is common when there is a high demand for rental properties, but low interest rates.
Benefits of positive gearing
- Your investment property is paying for itself, so the impact of the home loan on your overall debt obligations is heavily reduced.
- The investment property will be generating rental income, which means you can save money towards a deposit for another property or pay off your existing mortgage repayments.
- Additional income can increase your borrowing capacity if you are intending on building a portfolio of properties.
- Although your surplus income from a positively geared property is added to your taxable income, this is only after the interest and other costs incurred from your investment property are deducted.
Downsides of positive gearing
- As you are earning income from your property, this increases your taxable income, and thus the amount you will need to pay each year.
- Many positively geared properties are located in outer or regional areas, so your property may experience slower capital growth.
- If you are using your investment property primarily as a positive cash flow source, you’ll want to make sure there is a healthy buffer between your income and expenses to protect yourself against interest rate hikes.
- Rental rates could decline to the point where your rental income slips below your expenses.
What is negative gearing?
Negative gearing means that the cost of owning an investment property outweighs the rental income it generates. Returning to the above example, lets now say you continue to earn $20,000 a year, but now the expenses (loan repayments, body corporate fees, maintenance etc.) are $25,000. You now have a negative cash flow of $5,000.
Many people deliberately negatively gear their property, which may seem counter intuitive. After all, you presumably purchased the investment property to make money, so it might seem bizarre to deliberately lose money for a period. These losses though are deductible from your taxable income, which can reduces your tax bill. For example, lets say that you had a taxable income of $125,000 in the 2021/2022 financial year. According to the ATO tax brackets, this would have meant you had a tax bill of $31,317. However, now lets say that you also made a $20,000 loss on negatively geared investment properties. This now reduces your taxable income to $105,000, or a tax bill of $24,592, saving you $6,725. Your $20,000 loss is actually only $13,275.
While you are still making an overall loss, negative gearing is viable when you anticipate large capital gains in the value of your property. If your property appreciates by a bigger amount than the total value you lose over the loan term, your overall position has improved.
Benefits of negative gearing
- The ability to claim losses on the asset such as borrowing costs, building depreciation, and property expenses on tax to reduce your taxable income overall.
- Negatively geared properties are often in more hotly demanded areas like metropolitan centres which often means that the capital gains you can make as the property appreciates in value will more than compensate for the losses from your negative cash flow.
Downsides of negative gearing
- Since you’ll be making a loss each month, you’ll need to have a strong enough cash flow from other income sources to cover these losses.
- You are likely to have an annual cash flow shortfall until tax time when you can make your claims.
- If you have a highly geared investment property (or properties), an increase in the interest rates could compound your losses. Interest rate hikes also often see house prices take a hit, which could affect your capital gains.
- If you are intending to build a portfolio of investment properties, negative gearing can make this more difficult as losses will be taking up some of your extra capital.
Negative gearing vs positive gearing
To clearly understand the difference between positively and negatively geared property, the key differences have been highlighted in the table below.
| Positive gearing | Negative gearing |
|---|---|
| You’re making an ongoing net profit on the rental property | You’re making an ongoing net loss on the rental property - which can be offset against your taxable income |
| You have an extra cash flow which could go towards making extra repayments, renovations, savings, into an offset account, or even be used to buy another investment property | You need to have extra cash available to cover the net loss you’re making on the property |
| You may need to pay tax on your investment property's earnings | The net loss you’ve made could allow you to claim a tax deduction on your other income (e.g. if you made a net loss of $10,000 on the property and earn $80,000 per year, you may only need to pay tax on $70,000) |
| The property is generating rental income and capital gains | The property is solely generating capital gains |
Which strategy is right for you?
The choice between positive and negative gearing for your investment property will depend on your individual circumstances and what financial goals you want to achieve. For example, some investors choose to have a portfolio with both negative and positive geared properties.
Your investment strategies should be aligned to your personal circumstances and risk preferences, and you should consider consulting with a financial adviser before purchasing an investment property.
You should make sure you have a good understanding of how gearing works before you speak to a lender.
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