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What Is Negative Gearing?

This article will cover what negative gearing is, how it works, and how to know whether or not it might work for you.

In property circles, ‘gearing’ refers to borrowing money to buy an asset – in the case of property investment, by taking out a home loan to buy a property.

There can be positive gearing (where the rental income provides a profit above than the cost of the mortgage) or negative gearing (where the rental income is less than the cost of the mortgage).

The topic of negative gearing has been attracting quite a bit of attention recently, thanks to the current state of the Australian housing market. It has been called both a valuable cornerstone for the middle class mum and dad investor as well as an unnecessary tax break that is making housing unaffordable.

What is negative gearing?

Negative gearing is when the cost of the home loan for the investment is greater than the rental income received from the property.

In Australia, the property investor in this situation is currently able to claim a tax deduction for the amount of their loss for that financial year. For this reason, people have called negative gearing a ‘tax evasion strategy’ because the investment losses can be applied to offset the other income earned, enabling the investor to pay less tax.

As well as the tax concessions on offer for negative gearing, you can still make a long-term profit on your investment once the value of the property increases (if it increases at all) – but you have to pay capital gains tax on that profit.

Watch the video below for a visual case study of what negative gearing is all about and how it might work in practice.

Source: InvestSMART Group

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Changes to negative gearing in the 2017-18 Budget

In the 2017-18 Federal Budget, several changes were made to tighten the negative gearing rules around what can be claimed as a tax deduction.

The government has removed the negative gearing tax deduction that used to apply for property investors who made travel expenses to travel to and from their investment property when:

  • Inspecting the property
  • Maintaining the property
  • Collecting rent

Depreciation deductions for ‘plant and equipment’ property fixtures such as washing machines, ceiling fans, and more will also be limited to those directly incurred by investors. This is designed to prevent investors claiming a deduction where they have bought an investment property that already contained such property fixtures.

Property management fees for third parties such as real estate agents remain tax deductible for property investors.

The new rules come into effect from July 1 this year.

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What is positive gearing?

Positive gearing is a much more straightforward concept that its negative counterpart. Positive gearing is simply when the cost of holding your investment through interest is less than the income you receive from it. This is the ideal scenario for most property investors, as you are immediately making a profit on that investment.

Positive gearing isn’t always possible right away, however, which is why so many people turn to negative gearing.

How does negative gearing work?

Essentially, the basic goal of a negatively geared property is to turn a loss into a gain. You obviously shouldn’t invest in a property with the intention of making a loss, but if your property is not earning enough in rent to pay for itself, then at least you can write that loss off when tax time comes around.

There are many different reasons why the cost of a property can outweigh the income, but they can be divided into two different categories:

  • Non-cash costs such as the depreciation in the property’s value
  • Cash costs such as interest payments, bank fees, insurance premiums, property management fees, and more

If you add the amount of cash and non-cash costs together and they are more than your rental income from the property, then there is a net rental loss. You would then claim this loss as a tax deduction against your taxable income, such as your salary.

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What investment property expenses can be claimed as tax deductions?

If you own an investment property, then are several other expenses that you can write off as tax deductible. These expenses are related to the maintenance of the property:

To successfully make these tax deductions, you are required to keep official documentation of such expenses, including bank statements and receipts. You will also need an accurate depreciation schedule and capital works schedule.

As mentioned above, there are now some expenses that cannot be claimed as a tax deduction from July 1 onwards, thanks to the 2017-18 Federal Budget:

Pros and cons of negative gearing

As with any investment strategy, there are potential drawbacks as well as potential benefits to negative gearing. Many people lose money on negative gearing because they aren’t fully aware of the consequences.

Canstar has compiled a brief list of the pros and cons of negative gearing to give you some idea of how to work out for yourself whether it might be a good idea for your situation.

Pros

Reduce your taxable income:

Property investors can usually turn their investment losses into a positive by offsetting it against their taxable income, meaning they pay less in tax for that financial year. If you’re disciplined with your investments, then negative gearing is one way to absorb any interest losses over the short-term.

This enables low income earners and middle income earners to invest in property, which they likely would not be able to afford otherwise.

Capital growth:

Besides tax savings, arguably the biggest benefit of negative gearing is that it can allow an investor to afford to buy a property with the potential for high capital growth. Capital growth potential is the most common goal of property investors.

Properties that have positive cashflow immediately are hard to find, but even if there’s no immediate return, negative gearing allows you to more easily afford some properties that will increase in value in the future.

More property choice options:

By negatively gearing, investors can give themselves many more property options to choose from. Negative gearing can open up the range of properties someone can afford to invest in to include properties where the rent would not necessarily fully cover the mortgage to on it.

This can potentially allow an investor to potentially invest in safe, secure areas that are likely to provide regular rent, which is always a sound investment strategy, or in high capital growth areas.

Cons

Risk:

As with any investment strategy, there is a degree of risk that comes with negative gearing. Borrowing money to fund a property comes with the possibility of rising interest rates and depreciation in the value of your property, which can eat away at the potential capital gains.

Many people incorrectly assume that negative gearing is a fool-proof strategy to “save money” on tax, which is very dangerous. No investment strategy can be called “fool-proof” or “safe”, and significant losses are possible if the investor underestimates the amount of the loss they are making on their investment.

Dangerous for housing affordability in the property market:

Many people now simply see property as an investment, which is one of the causes of the skyrocketing house prices across the country. It drives up house prices while not doing much to generate supply.

Increasing house prices is not terrific for the economy as a whole because it means people are borrowing more and more money. It’s a trend that could well have negative long-term consequences.

More people borrowing more money:

While it’s actually the middle and lower income earners who are using negative gearing, negative gearing does lend itself to high income earners. Such people can afford to buy properties that don’t pay for themselves, on top of financing their usual lifestyle.

Negative gearing may encourage those with limited income to invest solely in one property because it’s all they can afford, rather than investing in a more diversified portfolio.

For further information on variable home loan products available for investing, the below comparison table has been formulated with direct links to the providers website. These have been sorted by our star ratings (highest to lowest). Please note that this table features products that are based on a loan amount of $750,000 for a property in NSW with a LVR of 80%.

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The risks and benefits of negative gearing

Borrowing to invest always carries a certain amount of risk, and negatively gearing a property is no different. In order for negative gearing to work, you generally need to have a sound understanding of how the process works, as well as knowledge of what expenses you can and can’t claim as a deduction.

In the wrong circumstances, things like falling rental prices, rising interest rates, and damage to your property by tenants or others, can all lead to significant losses for an investor. Investors can minimise some of these potential risks by asking themselves the 10 questions below, as well as studying market trends, and doing plenty of research when choosing and managing their investment property.

Should I use negative gearing? Is negative gearing right for me?

If a negatively geared property is an investment that you’re considering, then there are a few questions you need to ask yourself before making a commitment:

  • How rentable is the property? Is it in a good area? And will people want to live there?
  • What will I do if I can’t find a tenant?
  • Do I have the means to manage my property and the tenants that live in it?
  • What is the capital growth potential of the property?
  • Would I still be able to afford your repayments if interest rates rise?
  • How long will it take before the investment is positively geared?
  • Could I still afford to live comfortably on the money I earn, knowing that I would be losing money on this investment?
  • Will I be able to recover from a cash flow shortage?
  • Does the potential tax benefit I stand to make on holding the investment outweigh the cost of losing money on this investment?
  • Would other investment options be equally good? (e.g. investing in other assets such as managed funds or superannuation, or paying the money into the mortgage on your own home)

It’s always wise to consult a financial adviser before committing to what is a significant investment. They will be able to tell you if what you’re about to do is a good or bad idea.

Many successful investors ignore the tax deduction available on a property and simply look at the value the property can provide on its own, in order to determine whether it is worthwhile. Too many people simply look at the tax benefits, or they think that negative gearing will make it easy to own an investment property. Remember that there’s more to it than this, and seek professional financial advice when making investment decisions.

When you’re ready to choose an investment loan, Canstar compares thousands of home loans to help you find the right mortgage for your investment property:

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Case Study: Jessie and James use negative gearing

Jessie and James have just bought a geared apartment on the Gold Coast, which they bought in preparation for the 2018 Commonwealth Games. Let’s say that this investment cost them $10,000 in interest this year, and returned only $6,000 in income.

Since they are making a loss of $4,000 on this apartment, their investment is negatively geared. James claims this as a deduction at tax time.

Although the property is still costing Jessie and James money, their aim is to make a capital gain on the property when selling it, so they can achieve a positive return on their investment.

Source: www.canstar.com.au

For more tips about rental property deductions, check the ATO website:

Source: Australian Taxation Office

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