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As an investor, there's a chunk of options for property finance. While you’ve probably heard a lot of chat about negative gearing, you might be unsure what it actually means for your bottom line. And with thousands of dollars at stake (and the risk of paying a high amount of taxes on your investment property), it’s essential you make a savvy and informed decision.
Negative gearing can be an effective way to offset your income and reduce your tax bill. However, it’s important to understand exactly how this investment strategy works before you decide to negatively gear your investment property. Plus, there is heated debate about whether this investment strategy should be allowed to continue in its current form in the years to come.
In this guide, we give you a deep-dive into negative gearing, the pros, and cons of this approach, plus the potential tax and legal implications for you as an investor.
What is negative gearing?
Negative gearing is when the income you generate from your property investment (mostly rental income) is lower than your expenses. As a result, you make a net loss on a yearly basis.
How does negative gearing work?
While it’s most commonly linked with investing in property, negative gearing is a strategy that can be used for a range of investment types.
Let’s talk gearing. Gearing is financial jargon for borrowing money to buy an asset (such as property).
By negatively gearing your property, you're paying more in your mortgage and property expenses than you're receiving in rental payments. This means that your income is no longer taxable, and you can actually write off your expenses on your taxes.
While negative gearing is the most popular property financing strategy, the proportion of negatively geared investors is the lowest it's been now for 14 years.
It might sound like a counterintuitive approach, but negative gearing has proved a popular option for Australian investors. In fact, the AFR reported that 60% of property investors were negatively geared.
Let’s look at both sides of the coin to see why investors might (or might not) choose this investment strategy.
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What are the advantages of negative gearing?
There are two main benefits of negative gearing:
- Tax savings: as an investor, you'll be able to deduct any losses you make on your investment property from your taxable income, which can help to lower your property tax bill.
- Capital gains: investors are also banking on their property increasing in value when it comes time to sell, helping them to make a profit that counteracts the losses they’ve incurred across the lifetime of the investment.
If you're looking for more ways to cut your taxes, read our tips on how to get the most tax deductions from your investment property.
What are the disadvantages of negative gearing?
But, negative gearing does come with some drawbacks, which can include:
- Reduced cash flow: as you’ll consistently be making a loss, you won’t be able to generate a passive income from a negatively geared property. This can impact your cash flow and can make it challenging to cover the costs of maintenance, repairs, and unexpected bills.
- Capital loss: while the ultimate aim of negative gearing is for the property to increase in value, that doesn’t always happen in reality. As the market fluctuates, a negative gearing strategy can make you more vulnerable to losses (rather than providing stable and consistent returns over the lifetime of the investment).
What other financing strategies exist?
While negative gearing most commonly makes the headlines, there are a bunch of different ways to invest in property, each with its own pros and cons.
Positive gearing explained
As you’d expect, positive gearing takes the opposite approach. In this case, the money you borrow to invest and the income you earn from your investment is higher than your expenses.
If you’re looking for stable, consistent returns, positive gearing can deliver a reliable source of passive income. Plus, if your property does increase in value you might also make a capital gain when it comes time to sell.
However, the extra income you earn means you may need to pay tax on your investment earnings (which is something you’ll be wanting to reduce as an investors). It’s also more challenging to find properties that suit this strategy, meaning you may need to widen your investment property search to smaller, regional areas (where capital growth isn’t as high).
Neutral gearing explained
What happens when the money you borrow to invest and the income you make from your investment is equal to your expenses? That’s what is called a neutral gearing strategy.
This means you’re essentially breaking even, meaning there is no advantage or disadvantage when it comes to how much tax you pay.
This approach can be useful for those investing through a self-managed super fund (SMSF), as it won’t eat into the fund’s wealth.
To be completely honest with you, neutral gearing is something that we see very rarely. Realistically, it’s hard to actually align your income and expenses over the course of a year, especially factoring in vacancies. That’s why in reality most property investors either deliberately positively gear or negatively gear.
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What are the tax implications of negative gearing?
As we’ve mentioned, one of the biggest drawcards for negative gearing is the potential tax savings. Under Australian law, investors can deduct their losses against their income to lower how much tax they are obliged to pay when they report their taxes to the ATO.
As an investor, that means you can take advantage of tax deductions, including:
- Revenue deductions (such as interests, maintenance expenses and recurring costs such as agent fees, cleaning costs and even insurance)
- Depreciating assets (such as furniture, carpets, and curtains)
- Capital works (such as extensions, alterations or improvements to boost your investment property’s earning potential)
In some cases, these savings can help investors to increase their property portfolio, too.
Many investors who negatively gear their property are hoping to cash in when their property increases in value at sale time. However, making a capital gain does come with tax obligations (known as capital gains tax).
That means the capital gains you make are added to your personal income and can dramatically increase how much tax you need to pay. If you’re looking to reduce your tax obligations, it’s important to be aware of CGT and how this might impact your returns when it comes time to sell your investment property.
This does mean that tax time becomes more complicated. If that's something you're concerned about, a property manager can help.
Is negative gearing legal (and will that always be the case)?
While negative gearing can have attractive benefits for investors, it’s not without criticism. Many critics say negative gearing is increasing housing unaffordability by inflating property prices and making it difficult for first-home burgers to get their foot in the property door.
In recent years, both sides of politics have taken a strong stance on negative gearing. The Labor party had planned to restrict the practice of negative gearing ahead of the 2019 election, while the Coalition pushed hard in the other direction to defend negative gearing.
Recent ATO data has revealed that more than a quarter of Australians earning over $80,000 claimed net rent losses (compared with just 13.1% of Australians earning under $80,000). This indicated that those on higher incomes benefit most from a negative gearing strategy.
Many commentators are now calling for the Government to reform the tax concessions available to negatively geared properties in an effort to boost the supply of affordable rental housing in Australia.
While negative gearing remains a viable option to investors, policy reforms and tax implications may be up for debate in the years to come.
While negative gearing can be an effective strategy to reduce your tax bill and unlock lucrative capital gains, there are significant disadvantages to consider.
If you’re willing to accept a higher level of risk and can comfortably go without stable rental returns, negative gearing can be a worthwhile strategy to consider. Plus, negative gearing can help you to reduce your tax obligations to ensure you’re not paying too much tax on your investment property.
Ultimately, you’ll need to consider your own personal financial circumstances and investment goals to assess whether a negative gearing strategy is the best option for your needs.
How :Different can help you in property tax time
Our team of experts backed by intelligent technology can make managing your expenses a breeze. Talk to one of our friendly property experts to find out how we can help during tax time.
Disclaimer: The views, information, or opinions expressed in this blog post are for general information purposes only and should not be relied upon. We have not taken into account specific situations, facts or circumstances, and no part of this blog post constitutes personal financial, legal, or tax advice to you. You should seek tax advice from your accountant, specific to your situation.