Negative gearing explained

Negative gearing explained
When buying an investment property, negative gearing may become a useful tool. But it comes with its fair share of risk, so it’s important to understand exactly how it works to avoid getting in over your head.
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When buying an investment property, negative gearing may become a useful tool. But it comes with its fair share of risk, so it’s important to understand exactly how it works to avoid getting in over your head.

What is negative gearing?

‘Gearing’ means borrowing to invest in an asset; negative gearing means the cost of owning said asset exceeds any profits you make. So, if you make an annual loss on the ownership of a rental property, negative gearing can come into the equation.

How does negative gearing work?

If you purchase an investment property and rent it out to tenants, there’s a chance you may not make an immediate profit. This may happen if the rental income you receive doesn’t fully cover the repayments on your investment loan, or the property needs repairs/incurs other expenses that take away from the profit you’ve earned.

By negatively gearing your property, you can somewhat offset the net loss you make. Essentially, you can use the loss on your rental property as a tax deduction from your salary/wages or other taxable income. Let’s illustrate how this would work using an example.

Example of negative gearing

Let’s say you purchased a rental property for $500,000, and you take out a $400,000 mortgage to do so. With loans.com.au’s Smart Investor Loan, you would need to make monthly repayments of $1,630.85, or $19,570.20.

Let’s say your tenants are paying $325 per week. You pay property management fees of 5%, reducing your weekly rental income to $308.75. But the aircon needed to be fixed, leaving you with a $1,000 bill. Additionally, you had to call out a plumber to fix the toilet, which cost you $500.

You also needed to pay council rates, for example $2,000 over the year, and $350 for waste utility charges. You hold landlord insurance, which might cost you up to $4,000 over the year. Overall, your rental income for the year may be $8,205.

This means that your property is negatively geared by $11,365.20. So, instead of writing off this loss, it can become a tax deduction from your salary/other income. For example, if you had an annual salary of $70,000, you’d only need to pay tax on $58,634.80.

Related: How much does it cost to buy an investment property?

What are the benefits of negative gearing?

Negative gearing has a few key benefits that can make it worthwhile for some property investors.

Save money on tax

As mentioned, negative gearing allows you to save money on tax by reducing your taxable income. So if reducing your taxable income is the goal, negative gearing can be a way of achieving this. Reducing your taxable income may be helpful if you want to pay tax at a lower threshold.

Property can appreciate in value

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. For example, you might make a loss on the property for a few years, but when it comes time to sell, you might make a profit that negates any losses from the property’s increased value when you sell.

What are the drawbacks of negative gearing?

While these benefits can make negative gearing worthwhile, there are still some considerations that should be made before deciding whether it’s a good idea for you.

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 a 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 vs positive gearing is right for you will come down to your goals and financial situation. If you’re unsure about whether to negatively gear your investment property, you may find it helpful to speak to a financial adviser.

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