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What is negative gearing?
Negative gearing refers to the situation when investing in property or shares and the aggregate costs of owning the asset, such as loan interest, maintenance, and other expenses, exceed the investment income generated from the asset. This results in a financial loss for the investor. Negative gearing is often associated with property ownership, but it can also be applied to share investing.
However, this loss can be beneficial for investors because it can be used to reduce their taxable income. By deducting the loss from their overall income, they pay less tax. This strategy is popular among property investors as it may provide long term gains and provide some tax benefits along the way.
A simple example of negative gearing:
If you own a rental property and your annual expenses amount to $35,000, but you only earn $25,000 in rent, you have a $10,000 loss. You can then use this $10,000 loss to reduce your overall taxable income, which means you pay less tax for that year.
Four common myths about negative gearing
- Negative gearing is only for the wealthy: Many people think that negative gearing only benefits the wealthy. Any investor needs to have a sufficient level of taxable income to take advantage of the tax losses generated from negative gearing. A tax loss is still a loss if you cannot use it. You also need sufficient income to be able to meet loan repayments if there is no rental income should the property becomes vacant. It is more a question about your cashflow and whether you have the ability to be able to borrow funds to invest.
- Negative gearing means a guaranteed profit: Another misconception is that negative gearing guarantees a profit. In reality, it involves financial and market risk. The strategy relies on the property increasing in value over time to offset the initial losses. If the property value declines, investors could face significant losses. If the investor is unable to meet the shortfall in expenses associated with the property, then the investor will suffer losses.
- Negative gearing provides an immediate tax refund: Some believe that negative gearing provides an immediate tax refund. However, it actually reduces taxable income, which can lower the amount of tax owed at the end of the financial year. It's not an instant cash refund.
- Negative gearing is always beneficial: People often think that negative gearing is always beneficial. While it can be a useful strategy, it's not suitable for everyone. Investors need to consider their financial situation, risk tolerance, and investment timeframe and overall goals before deciding whether negative gearing is appropriate for them. They also should seek a professional advice from a Financial Adviser and Tax Adviser.
Understanding these misconceptions can help investors make more informed decisions about whether negative gearing is the right strategy for them. It is always a good idea to seek professional advice tailored to your specific circumstances.
Keep in mind that this is not a straightforward process and seeking professional advice is very critical to determine whether a negative gearing strategy is appropriate to your overall circumstances.
Negative gearing is considered high risk as it involves borrowing money to invest. It also relies on you having sufficient income to meet any shortfalls in outgoings as the rental income will not cover all expenses in the short to medium term.
FREQUENTLY ASKED QUESTIONS
The income loss generated as a result of negative gearing can be used to offset overall taxable income thereby reducing your taxable income and potentially reducing your tax liability.
Negative gearing can influence the property market by increasing demand for investment properties, which can drive up prices and impact housing affordability.
Negative gearing is one of the common strategies used by investors to accumulate wealth outside of their primary residence and superannuation. It is beneficial for people who have surplus cashflow and have a high-risk tolerance and long-term horizon.
Negative gearing can be an attractive strategy for property investors, but it's important to be aware of the potential risks involved. Here are some key risks to consider:
- Market fluctuations: Property values can go up and down. If the market declines, the value of your investment property might decrease, leading to potential financial losses when you sell.
- Interest rate increases: If interest rates rise, your mortgage repayments will also increase. This can make it more expensive to hold onto a negatively geared property and might reduce your overall returns.
- Rental income variability: There is no guarantee that your property will always be rented out. Periods of vacancy can lead to a loss of rental income, making it harder to cover your expenses.
- Tax law changes: Government policies and tax laws can change. If the rules around negative gearing are altered, it could impact the financial benefits you receive from this strategy.
- Cash flow issues: Negative gearing relies on the expectation that the property's value will increase over time. However, in the short term, you need to have sufficient cash flow to cover the ongoing losses from the property. This can be challenging if your financial situation changes unexpectedly.
- Maintenance and repairs: Owning a property comes with ongoing maintenance and repair costs. These expenses can add up and impact your overall profitability.
- Illiquidity: Property is regarded as illiquid assets. There also high transaction costs associated with buying and selling property – stamp duty and capital gains tax. Also if you need immediate access to funds, you cannot just sell one part of the property, you have to sell the entire property so high transactional costs and tax liabilities are inevitable.
Understanding these risks can help you make more informed decisions about whether negative gearing is the right strategy for you. It's always a good idea to seek professional advice tailored to your specific circumstances.
Grace Bacon is a Director of RSM Financial Services Australia (AFSL 238 282), advising clients on wealth management, retirement planning and succession planning.
If you have any further questions on negative gearing or other wealth management strategies, reach out to Grace or your local RSM financial adviser.
This article first appeared in the Sydney Morning Herald, The Age, Australian Women’s Weekly and Brisbane Times.
