The Ultimate Guide To Positive and Negative Gearing
Investing in rental property is a great way to build wealth and create passive income. However, it is also a risky game. With this in mind, it’s important to know the rules before playing. You will also need to be aware of what you’re getting into and how your actions will impact your finances.
Australian property investors are often looking for ways to leverage their property investment potential by using negative gearing or positive gearing strategies. Positive gearing is arguably more conservative than negative gearing, but a negatively geared property could yield great tax benefits and potentially reduce your tax bill.
This blog post provides an overview of these two methods and then digs deeper into how they work, outlining the benefits and drawbacks of each method so you can make informed decisions about which one to use when investing in property.
What’s the Difference Between Positively and Negatively Gearing Your Investment Property?
If you’re looking to buy an investment property, you may have heard the term ‘gearing’ used. Gearing simply means that you’ve used a home loan to finance the purchase of your investment property.
There are two main types of gearing – negative and positive.
Negative gearing is when you borrow money to invest and your loan interest and other expenses are more than the rental income you receive from the investment property. This means that you’re running at a loss each month, but you’re hoping that the value of the property will increase over time so that you can make a profit when you sell.
Harry bought an investment property in 2020 for $560,000.
He was able to pay a deposit of $112,000 and the other $448,000 was funded by a mortgage loan. Based on an interest-only agreement and a 3% interest rate, Harry’s annual interest repayments would be about $25,800.
Harry manages to secure tenants and charges a weekly rental of $450, which totals $23,400 in annual rental income. This means that he is running at a loss:
$23,400 annual rental income – $25,800 annual loan repayments = -$2,400
Therefore, Harry’s investment property is negatively geared.
Positive gearing, on the other hand, is when your rental income is greater than your loan interest and other expenses. This means that you’re making a profit each month, which can then be reinvested or used to pay off your loan faster.
Joey also bought an investment property in 2020 for $480,000.
He was able to pay a deposit of $96,000 and the other $384,000 was funded by a mortgage loan. Based on an interest-only agreement and a 3% interest rate, Joey’s annual interest repayments would be about $22,100.
Joey manages to secure tenants and also charges a weekly rental of $450, which totals $23,400 in annual rental income. This means that he is generating a profit:
$23,400 annual rental income – $22,100 annual loan repayments = $1,300
Therefore, Harry’s investment property is positively geared.
There are pros and cons to both strategies, and it’s important to talk to a financial advisor to see which one would be best for your situation.
Why Run at a Loss? Well, it Can Reduce Your Taxable Income
When it comes to investment, most people look for ways to make a profit. But with negative gearing, you’re using the rental income to cover the cost of the loan. And if your rental income is lower than your loan interest, essentially, it means that you are making a loss on your investment.
So, why would anyone do this? There are a few reasons why.
Firstly, negative gearing can be used to reduce your taxable income. This is because you can offset the loss from your other forms of income. So if you’re buying property to experience long-term capital growth and not necessarily for the rental income, you can usually use the negative gearing strategy in conjunction with the buy and hold investment strategy.
The buy and hold strategy is a popular choice for investors who are looking to generate capital growth from their property investments. The idea is to purchase a property and then hold onto it for a period of time, usually several years. During this time, the value of the property is expected to increase, providing the investor with a healthy return on their investment.
With these two strategies, rent can help cover most of the expenses, and you cover the rest. But come tax time, you can benefit from a reduced taxable income.
Besides using the negative gearing strategy to offset your other forms of income to reduce your taxable income, the Australian Tax Office also allows you to claim various tax deductions to further reduce your tax burden, including:
- interest on your investment loan; and
- rental expenses.
What are the Drawbacks of a Negatively Geared Investment Property?
Although negative gearing can be a useful tool for investors, there are some potential drawbacks to consider.
First, the rental income doesn’t cover the mortgage repayments and other costs, so you’ll need to make up the difference from your personal income. This can put a strain on your finances and make it difficult to meet your other financial commitments if you’re not able to sustain the loss.
Second, negative gearing can lower your borrowing power, as lenders may take into account the losses you’re likely to incur when assessing your loan application. Finally, if you eventually sell your property for a capital gain, you’ll have to pay capital gains tax on that gain (although you could utilise a capital gains tax 50% discount if held for longer than 12 months).
Negative gearing can therefore have a significant impact on your financial situation, both in the short and long term. It’s crucial to ensure that the benefits outweigh the drawbacks in relation to your personal financial circumstances.
What are the Pros and Cons of Positive Gearing?
Positive gearing is a rental strategy where the rental income covers the cost of the mortgage, leaving the investor with a profit. This can have several benefits, including increased borrowing power and helping to balance your portfolio to cover the losses of your other properties.
Rental Income Generates a Profit
One of the main advantages of positive gearing is that it can generate a profit. This extra income can be used to pay off debts or invest in other property. Positive gearing can also help to increase your borrowing power as lenders see that you are able to cover the cost of the mortgage. This can be helpful when you are looking to purchase additional investment properties.
Finally, positive gearing can help to balance your portfolio by offsetting the losses of your other properties. This can help to reduce your overall risk and improve your chances of generating a return on investment.
Of course, there are some pitfalls too.
Increased Profit Means More Income Tax
One of the downsides of positive gearing is that it increases your taxable income. This is because the rental income you receive is added to any other income you earn, such as wages or interest on savings account investments. As a result, you may find yourself in a higher tax bracket and owing more tax at the end of the financial year.
But don’t forget to claim those tax deductions we mentioned earlier in the blog post. This can definitely help reduce your tax burden.
Another potential downside of positive gearing is that the properties that are most likely to be positively geared are usually located in regional towns rather than capital cities. This means that you may experience slower capital growth on your property as it is less likely to increase in value as quickly as properties located in areas with stronger economic growth.
Positive or Negative Gearing Australia: Which Strategy Is Best For You?
Weighing up whether to positively or negatively gear your investment property is no easy feat – there are a lot of factors to consider. Ultimately, it comes down to your personal circumstances and investment goals.
If you’re looking to generate a monthly income, then positive gearing may be the way to go. But if the capital gain is your only goal and you’re in a comfortable enough financial position to cover your losses, then negative gearing could be the way to go.
That said, economic and property market fluctuations can also play a role in which strategy is best for you.
Of course, trying to navigate these waters alone can be tricky. That’s why it’s often beneficial to have a team of experienced property professionals in your corner to help you make the best decision for your portfolio.
How Can Property Tax Specialists Help?
If you’re like most people, the words ‘negative gearing’ and ‘positive gearing’ probably make your head spin a little bit. After all, there’s a lot to consider when it comes to investing in property. But don’t worry – that’s where Property Tax Specialists can help.
We’ll get to know you and your unique circumstances, and then develop strategies that consider aspects of your business, investments, income, family, and lifestyle goals. Our emphasis is on protecting assets and taking advantage of opportunities to minimise tax within legal constraints.
So if you’re trying to figure out whether negative or positive gearing is right for you, give us a call. We’re here to help!
As you can see, there are many factors to consider when deciding between the two types of investment strategies.
We recommend contacting a professional for more information and advice about which type of strategy is best suited for your needs.
We have experience working with both positive and negative gearing investment properties over the years, so get in touch today.
DISCLAIMER: This information has been prepared without taking into account your objectives, financial situation, or needs. Because of this, you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation, or needs.
Amir Ishak is a Limited Authorised Representative 1269908 of Merit Wealth Pty Ltd, Australian Financial Services Licence 409361, ABN 89 125 557 002