How does negative gearing work?

When talking about ‘gearing,' we’re referring to borrowing funds to invest in an asset. Positive gearing is when you make a profit from your investment. Negative gearing happens when the cost of owning said asset exceeds your profits.  

At first, negative gearing may sound like a losing strategy, but some property investors offset the loss against other taxable income. Doing this can be risky, so understanding exactly how negative gearing works is essential to a successful investment endeavour. 

How does negative gearing work? 

Negative gearing is when you’re operating your rental property at a loss. For instance, if the rental income you receive doesn’t fully cover the repayments on your investment loan or other maintenance costs, you’ll have to pay out of pocket to make up the rest.  

With rental properties, there’s always a chance you may not make an immediate profit. By negatively gearing your property, you can somewhat offset the net loss you make. It’s a strategy that relies less on profit from tenants and more on the projected long-term growth of the property. 

You can use the loss on your rental property as a tax deduction from your salary/wages or other taxable income. 

Example of negative gearing 

Let’s say you purchased a rental property for $800,000, and you took out a $700,000 mortgage to do so. With loans.com.au’s Variable Investor Home Loan, your monthly repayments would be approximately $4,237.  

If your tenants are paying $615 per week and your property management expenses take up around 10% of that, your weekly rental income comes to $553.5. That’s not accounting for emergency repairs, which could be expensive depending on what appliance needs fixing. If you have landlord insurance, that’s an additional $4,000 in yearly expenses. 

You also need to pay for council rates, which are determined by your home’s land valuation or rateable value and the council’s dollar rate. Depending on where you live, let’s say your council rates are around $2,000 a year. 

In a year, you could make around $31,980, but excluding all the mentioned expenses (around $56,844), your property is negatively geared by $28,062. If you’re pre-tax salary is $100,000 annually, you only need to pay tax on $71,938 of that. 

Why do investors use negative gearing? 

When your property is negatively geared, you’re essentially operating at a loss, which seems quite antithetical to the whole concept of investment. So, why do people do it? Negative gearing has a few key benefits that can make it worthwhile for some property investors, such as: 

• Saving money on tax – Negative gearing allows you to save on tax costs by reducing your taxable income. Reducing your taxable income could be helpful if you want to pay tax at a lower threshold. 
• You can recoup costs when selling – Having a property that’s making an annual net loss can be an acceptable trade-off if the property is expected to go up in value. You might make a loss on the property for a few years, but could make a profit that negates any losses from the property’s increased value when you sell. 

What do you need to look out for with negative gearing? 

While these benefits can make negative gearing worthwhile, there are also drawbacks you need to be aware of before making a decision. 

Increased value isn’t promised – If you’re relying solely on the property value increasing despite there being no guarantee that this will happen, negative gearing may not be the strategy best suited to you. 

No passive income – Many people choose to invest in rental properties to generate passive income, grow their wealth, or build a property portfolio. However, if your property is negatively geared, you’re not receiving passive income; rather, you’re spending additional income to maintain ownership of the property. 

Is negative gearing worth it? 

You might find that negative gearing works for you if you have additional income, you can handle an additional mortgage, and the property is set to rise in value. If your goal is to build a property portfolio and wealth, it might not be the right avenue for you to do so. 

Ultimately, the choice of whether you choose negative versus positive gearing will come down to your goals and financial situation. If you’re unsure about whether to negatively gear your investment property, you should speak to a financial adviser. 

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