(article shared from http://www.smartpropertyinvestment.com.au/markets-a-research/14935-what-is-negative-gearing)
Negative gearing – the media, politicians and investors love talking about it, but what does it actually mean and why is it an important consideration when devising your property investment strategy?
It seems that negative gearing policy is always hitting the headlines. Negative gearing can be an essential part of a property investor’s strategy – but it is important to understand the policy, how it should be used and how it can affect your buying behaviour.
What is negative gearing?
‘Gearing’ simply refers to borrowing to invest in an asset, be it property or otherwise. In terms of property, it refers to taking out a loan to purchase a property.
When an investment is negatively geared, it means that the interest paid on this loan is exceeding the rental income provided by the property – resulting in a loss.
This is opposed to when a property is neutrally geared, or positively geared. Neutral gearing refers to the scenario when the interest on the loan is equal to the income generated by the rental property in question.
When an investment is positively geared, it means that the income generated by the property exceeds the loan repayments on the property – resulting in a profit.
To give an idea of when a property would be considered to be negatively geared, let’s consider the example below.
Imagine you bought a $540,000 property and took out a $500,000 loan at an interest rate of seven per cent. The annual interest payable on the loan is $35,000.
Let’s also imagine that you are earning $530 per week in rent, which adds up to an annual rental income of $27,560.
Based on the above example, you are paying $35,000 in interest but only earning $27,560 in rent – resulting in a shortfall of $7,440 per year. In this case, the property is negatively geared.
Negative gearing policy explained
Many investors get into property investment to benefit from longer-term capital growth, but having an investment property in some of Australia’s more competitive real estate markets can often mean sacrificing a strong rental yield, and therefore making a short-term loss on an investment property.
The idea here is that as property prices increase rapidly (ie capital growth), rental prices fail to keep pace with this growth. In this case, investors are banking on making their money through the change in their properties’ values, rather than solely relying on the income generated from the rental payments they receive.
In Australia, negative gearing attracts a tax concession or benefit on both property and shares investments. When a property investor is ‘losing’ money on their investment due to the loan repayments, they can write-off the loss each year as a tax deduction – effectively reducing their taxable income and making up for some of the loss experienced.
In the case outlined above, the $7,440 shortfall would be removed from the investor’s taxable income. If, for example, their taxable income was $90,000, negative gearing would enable them to reduce this to $82,560.
Negative gearing can be used with other tax policies such as depreciation claims and related expense write-offs (such as property management fees) to bridge the gap between profit and loss each financial year. Depending on how significant the negative gearing scenario is, this may be enough to render the rental income deficiency inconsequential.
For information on how negative gearing should be calculated into your tax return, refer to the ATO website.
Why would an investor choose to be negatively geared?
In an ideal world, investment properties would provide solid long-term capital growth as well as a profit from rental income. Unfortunately, securing such investment properties can be a difficult process.
It could be that, in order to secure a property that promises impressive long-term capital growth, investors need to sacrifice short-term rental income and engage a negative gearing strategy.
This is particularly the case in capital city markets – where long-term growth drivers such as population increases, infrastructure projects and employment opportunities exist, but the sheer volume of rental stock and competition between investors means that buy-in prices are high and the ability to charge a rental rate that would provide an immediate profit is limited.
It may be that an investor decides that achieving this long-term increase is worth the short-term sacrifice, and so a negatively geared investment will work within their investment plan.
It is important to note that negative gearing is generally not designed to be a long-term investment practice. The idea is that investors will use the tax concession to limit the pain whilst they progress on the loan repayments outstanding on their property – until they reach a point where the property becomes neutrally or positively geared.
What are the disadvantages of negative gearing?
The disadvantages of negative gearing revolve largely around the income of an investor – indeed, your income will likely determine whether you can afford to buy a negatively geared property (and your tax bracket may influence how much of a benefit any deductions yield).
If you are on a low to mid-range income and are seeking to expand your property portfolio within a short period of time, holding a negatively geared property has the potential to limit your ability to save for your next deposit.
Remember that holding an investment property involves far more than simply meeting the loan repayments – and maintaining a cash reserve to dedicate towards property upkeep, or periods where the property is unoccupied, becomes a more difficult task when a property is negatively geared.
Holding several negatively geared properties has the potential to create financial stress associated with meeting repayments, and it places increased importance on the investor staying in their current employment or gaining a higher-paying job.
There is a degree of risk involved with negative gearing, and an increased onus on the investor selecting an area that will experience significant capital growth. The future returns on the property need to exceed the cumulative difference between loan repayments and rental income throughout the time of ownership.
If property values don’t move up, and rents don’t go up either, the investor will have sacrificed years of cash flow for little in return. For the sacrifice of holding a negatively geared property to pay off, the property needs to provide good long-term returns.
Is negative gearing here to stay?
The other big risk with choosing to invest in a negatively geared property for a long period of time is the amount of political uncertainty surrounding the policy. Australia is one of the only countries in the world to feature negative gearing as a taxation policy, and a degree of doubt exists over its longevity.
There are many arguments concerning whether the policy of allowing deductions on negatively geared property investments is good or bad for the real estate market at large.
Many proponents of the policy argue that it encourages investment in housing stock, increasing rental availability and driving construction employment.
Arguments have also been made that negative gearing adds an artificial level of increased competition to the real estate market – driving up prices for owner-occupier buyers, forcing them to remain renters and thus playing into the hands of ‘already rich’ investors.
The policy has previously been abolished by the federal government – in the 1980s – before being reinstated a short time after and it continues to feature prominently in debate surrounding taxation.