Negative Gearing 101: Fool’s Gold or Smart Investment Strategy?

You’ve probably heard the term ‘negative gearing’ being bandied about by investors, but do you really know how it works and why it’s often called fool’s gold? Shukri Barbara explains

Generally, people invest to get a positive result. So why do they adopt a negative gearing strategy? A negative gearing strategy trades off tax deductible rental losses during the ownership period against a projected capital gain on the sale of the investment property where only 50% of the capital gain is taxable.

Critically, the investor is receiving all the growth on the portion financed
by the lender, and is thus leveraging the investment with a small deposit.

‘Gearing’ is a term used in engineering. In car technology, when you
have a manually operated car there is a gear shift, which has several settings.

Level one is usually used to get the car to move from stationary position, generally very slowly. Once it starts to move, shifting into second gear moves the car with some power but still relatively slowly. As the car moves with more power, the driver is more easily able to pick up speed by shifting to higher gears as the car can now move quite fast.

Similarly, the use of pulleys allows people to lift heavily weighted items
almost by themselves.

In property investment terms, borrowing money to finance the purchase of a rental investment is similar to shifting the gear in a car to get it to move faster, or using the pulley to lift that heavy load singularly. A small deposit is ‘geared’ up with a loan to enable the investor to acquire a rental property investment that would otherwise not have been possible.

Gearing into an investment property can be ‘positive’ or ‘negative’, depending
on whether the interest expense will result in a net rental profit or net loss after all expenses are covered.

Positive gearing

A ‘positive gearing’ result producing a net rental surplus/profit instead of a loss will be achieved if, for example, the net rental expenses are only 1% ($5,000) and the interest rate has fallen to 5% ($20,000). After taking depreciation into account, additional cash from the tax savings will have been generated.

For tax benefits to contribute positively, the investor has to be on a high marginal tax rate. He also has to have enough cash to cover the cash rental loss each year of ownership.

Risk areas associated with negative gearing strategies include interest rate fluctuations and net capital growth not exceeding rental losses.

As the tax-free threshold has moved to $18,200, negative gearing strategies will not suit those with a taxable income below this amount. The benefits are low for those on the 19% (+1.5% Medicare) rate with taxable incomes between $18,200 and $37,000.

Is negative gearing for you?

In my experience, I have found that negative gearing strategies have worked well for investors who purchased well-positioned properties and held o to them for a long time, riding at least one property cycle, if not more. Very high inflation increased the value of the properties, while the value of the loans fell as increased income made serviceability easier. Other investors who benefited were those who bought well in the first place.

Negative gearing: How it works in real life

Take the example of a property valued at $500,000. A rental of $500/week produces a gross yield of 5.2% (assuming it is rented for 52 weeks).

Rental expenses include agent’s fees for collecting rent and managing property; water and council rates; strata levies (if a unit); repairs; and maintenance land tax (where the land value exceeds the threshold). For the sake of this exercise, assume the total operating expenses add up to 1.5% of the value of the property. This amounts to $7,500.

The net rental cash return of $18,500 ($26,000–$7,500) is now 3.7%, compared to the gross yield of 5%. Gross-yield measurements should not be used for decision-making in isolation.

More analysis is recommended, considering the personal circumstances of the investors, their strategies and goals, potential growth rates, rental increases for the property, etc. The cost of gearing is ‘interest’ expense. While lenders can lend more, and they do, assume a more acceptable 80% loan-to-valuation ratio (LVR). In our example, this would enable a $400,000 loan to be taken. At an average 6% rate the total interest expense for the year would be $24,000 ($400,000 x 6%), exceeding the net cash generated ($18,500) and resulting in a ‘negatively geared’ net rental loss of $5,500.

The net rental loss can be further reduced, because it can be claimed as a tax deduction against other income such as salary, investment and business income on the tax return. Where the marginal tax rate is, say, 37% plus 1.5% Medicare, there would be a tax reduction (or additional refund) of $2,118, reducing the loss to $3,382.

With no cash to be used but only a calculation, the tax system allows a claim for deducting the cost of depreciating plant and equipment as well as the cost of construction (for buildings constructed from 1985).

This results in a greater tax saving. While most investors use the convenience of cost estimators/ quantity surveyors to calculate this figure for newly acquired property, an assumption is made here that the total deduction is 1.65% of the value of the property, at $500,000, making the claim for deduction $8,250.

At a marginal tax rate of 38.5%, an additional tax saving of $3,176 is generated, making the net out-of-pocket expense a very minor $206. For someone with a taxable income well above $180,000, where the marginal tax rate is 46.5%, the tax savings would exceed the rental expenses, producing a positive cash surplus.

Where a large refund is expected, cash flow can be improved by lodging an application with the ATO to allow the employer to reduce PAYG withheld. This means the equivalent of the tax refund expected from negative gearing is accessed earlier than at the end of the financial year.

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