What You Should Know About Positive and Negative Gearing

Investing in property involves many technical intricacies that you must know to make a wise financial decision and understanding positive and negative gearing one of them.

Gearing refers to borrowing money to buy an asset. It is further divided into two types: Positive Gearing and Negative Gearing. Negative Gearing is a highly discussed topic in the industry. Investors often choose to hold onto their negatively geared property to reduce their taxable income. However, the government’s gearing policies can significantly impact everything from the housing value to the average weekly rent. Therefore, you (property investors) must understand the benefits and implications of positive and negative Gearing.

What Is Negative Gearing?

Negative Gearing is a tax benefit you can claim on your total taxable income at the tax time if the investment you made using borrowed funds produces lower cash flows than the borrowing costs. If your investment property is making a loss because of expenses, it can offset the value of net loss against your taxable income. The expenses incurred running the investment involve home loans, council rates, maintenance, real estate agent fees, and upkeep costs. 

 

Negative Gearing Example

Here’s an example of a negatively geared investment property that Max bought for $450,000. 

Here’s an example of a negatively geared investment property that Max bought for $450,000.
Max’s annual earning = $100,000.
Yearly rental income of the property = $20,800 (money in)
Yearly interest repayments = $10,800 (money out)
Yearly property costs (expenses) = $15,000(money out)

Total income = $20,800
Total expenses = $25,800
Net Loss = $5000

That’s a case of negative gearing because it involves a loss. However, this net loss could be deducted from Max’s total income, which means he will be taxed on a lower amount.

The tax benefit would be something like this:

Taxable income = $100,000 annual salary (before tax)
Tax deductions = $5000 (from investment property loss)
New taxable income = $95,000
Tax savings = $1,850 for the period (based on the Tax Rates as of last year)

 

Benefits of Negative Gearing

 

  • Negative Gearing is beneficial in the long-term capital gain if you are building wealth. This gain often offsets the short-term loss. Most investors accept a loss because they know that capital growth will compensate in the future when the property appreciates in value. 
  • It is a better option for high-income individuals because negative gearing will decrease the tax on the property if it’s making a loss.
 

Does Negative Gearing Have Any Risks?

 

Negative Gearing has some risks associated, which can include:

  • Lack of cash flow for repayments: When you borrow money and consistently make a loss from the investment property, this can impact your cash flow and make it challenging to repay the interest, cover the maintenance, repairs, and unexpected bills.
  • Lack of tenants (no rental payments): If you cannot find a tenant and the property remains vacant for a long time, you will have to bear the loss of rental payments.
  • Property depreciation: If the depreciation value of the property increases or any changes in tax laws occur as the market fluctuates, a negative gearing strategy can cause losses.
 

What Is Positive Gearing?

 

Positive Gearing is when your earnings from the investment property are higher than the cost of owning the property (loan repayments, interest rates, water, maintenance, and repair costs). Therefore, there is a profit (positive cash flow) on your investment property in positive gearing when you are making an income.

 

Positive Gearing Example

 

Positive gearing is a lower risk strategy as compared to negative gearing. Let’s consider again the example of Max, who bought an investment property for $450,000.

 

Annual income = $100,000
Rental Income = $28,600 (money In)
Interest Repayments = $10,800 (outgoings)
Other expenses per year = $15,000 (outgoings)
Net Profit = $2,800 ($28,600 – $25,800)

 

The taxable income would be = $102,800 [$100,000 annual salary + 2,800 (net profit)]

In positive Gearing, Max has to pay more income tax and miss out on tax expense deductions.

 

Benefits Of Positive Gearing

 

  • In positive gearing, the surplus income may cushion investors from market fluctuations (home loan repayments, increase in interest rate, and unexpected property costs).  
  • It’s a good option for investors aiming to increase taxable income, leading to more borrowing capacity. 
  • Investors can invest extra cash flow to repay the loan faster, cover the expenses, or use it elsewhere.
  • Positive gearing is much like having your cash tied up as a deposit and is, therefore, a longer-term investment.
 

Does Positive Gearing Have Any Risks?

 

Yes, positively geared properties can have some disadvantages, such as:

  • Taxable income: The investor will get into a higher tax bracket because the profit on the investment property will be taxed like any other income.
  • Slow growth: Often, positively geared properties are located in a neighbourhoods with an uncertain future.
 

How To Minimise The Risks Of Positive And Negative Gearing?

 

  • Choose your investment property carefully that’s likely to increase in value throughout the investment period.
  • Earn a sufficient income to cover the repayment costs, maintenance, and ongoing repairs if your tenants are late with their rental payments or if your property remains vacant for any time. 
  • Take out landlord insurance for the investment property.
 

Which One Is Better?

 

The negative and positive gearing depends on your financial goals and situations. If you are making an investment based on any gearing strategy, speak to your financial adviser or a home loan broker to know the potential benefits and risks involved.

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