Negative gearing is a popular investment strategy in Australia, particularly among property investors.
But what does it mean, and how does it work?
Here’s a clear breakdown of negative gearing, the tax implications, and why it’s an appealing option for some investors.
What Is Negative Gearing?
In simple terms, negative gearing occurs when the costs associated with owning an investment property (like mortgage interest, maintenance, and other expenses) exceed the income generated from that property. This creates a loss for the investor. In Australia, investors can offset this loss against their other income, reducing their overall tax liability.
How Does Negative Gearing Work?
Let’s look at an example:
Suppose Sarah buys an investment property and rents it out. Her annual rental income is $20,000, but her expenses are higher:
- Mortgage interest payments: $25,000
- Property management fees: $2,000
- Repairs and maintenance: $1,000
- Insurance: $800
- Council rates and other fees: $1,200
Her total expenses add up to $30,000. Since her expenses exceed her rental income by $10,000, Sarah’s property is negatively geared. This $10,000 shortfall is the loss she incurs from the investment.
Tax Benefits of Negative Gearing
In Australia, the loss generated from a negatively geared property can be used to reduce the investor’s taxable income, which in turn lowers the amount of tax they pay. For example, if Sarah’s taxable income was $80,000, her $10,000 loss would bring her taxable income down to $70,000. As a result, she would pay less tax for that financial year.
This tax relief can make property investment more accessible for people who might otherwise struggle to cover the costs. However, it’s essential to remember that while this strategy offers tax advantages, it does not guarantee long-term profit.
Why Investors Choose Negative Gearing
Negative gearing can be attractive for several reasons:
- Tax Reduction: As shown in Sarah’s example, a negatively geared property reduces an investor’s taxable income, leading to tax savings in the short term.
- Capital Growth Potential: Many investors choose to absorb the initial losses, hoping the property’s value will increase over time. If the property appreciates significantly, the investor could sell it for a profit, ultimately offsetting any initial losses.
- Wealth-Building: Some investors use negative gearing as part of a broader wealth-building strategy. Holding onto multiple negatively geared properties may achieve substantial capital growth over the long term, building a diverse property portfolio.
Risks and Considerations of Negative Gearing
While negative gearing can be beneficial, it’s not without risks:
- Dependence on Capital Growth: Negative gearing relies on the property’s value increasing over time. If property prices fall or stagnate, the investor could face ongoing losses without the benefit of long-term gains.
- Cash Flow Impact: Since rental income doesn’t cover the property’s expenses, the investor must cover the shortfall out-of-pocket. If the investor’s financial situation changes, this could create a cash flow strain.
- Tax Policy Changes: Tax laws around negative gearing could change, impacting future tax benefits. Investors should stay informed and consider the potential for policy shifts when planning their strategy.
Is Negative Gearing Right for You?
Negative gearing can be an effective way to grow wealth if approached with a long-term view and realistic expectations. However, it’s essential to assess whether you can sustain the costs of a negatively geared property and whether the potential for capital growth aligns with your investment goals.
Speaking with a financial advisor or tax professional can clarify how negative gearing fits into your financial strategy and help you make informed decisions.
