Negative gearing…..a topic that polarises most financial advisers and confuses most investors. So is negative gearing a good strategy? Can it be used to as a profitable strategy for Property Investors? In this article we look at exactly what negative gearing is and the difference between negative and positive gearing.
What is a negatively geared property?
A negatively geared property is one that is purchased with the assistance of borrowed funds and the net rental income, after deductions and other expenses is less than the interest on the borrowings. For example, if your rental payments are $2,000 a month, but your interest payments and expenses for the property come to $2,400 a month then you are negatively geared by $400 per month. So in other words, holding this property costs you $400 a month or $4,800 per year. You can then claim this out of pocket expense as a deduction on your income tax. If you were paying 37c in the $1 then you would be able to claim $1,776 in your tax, which reduces your total out of pocket to $3,024.
So how do people make money on property?
So yes the tax is reduced, but you are still out of pocket over $3,000 for holding this property. So how do people make money on property? There is an expectation in Australian property that most properties will double every 8-10 years. So where people make money is in the capital growth. If they can afford to be out of pocket $3,000 per year for 8-10 years and hold the property then the capital growth should more than compensate them for their short term losses. Most savvy investors wouldn’t invest purely for the tax deduction, but it does help them to reduce the out of pocket holding costs they are experiencing each year.
And what about positively geared property?
Alternatively, some financial advisers will advise to have positively geared property. This is where the net rental income after deductions and expenses is more than the interest on the borrowings. For example, if your rental payments are $2,000 a week, but your interest and expenses on the property come to $1,800 a month, then you are positively geared by $200 a month. This is a profit of $2,400 a year. If in the same example you were paying 37c in the $1 for your tax, you would also be paying tax on this as it is income. You would pay $888 per year in income tax, leaving you with a total profit of $1,512 a year. There is a view that in some cases those properties that are positively geared experience less capital growth than those negatively geared. However, this isn’t always the case.
So which is better? It really comes down to your circumstances and what is available to you. For instance, for many properties if you borrow 80%, then it will be negatively geared. You may be able to find a property that has a higher rental demand and therefore you can charge a higher rent and this helps to make it positively geared. You may also be able to make it negatively geared by having a lower loan to value ratio and therefore reducing the loan repayments. For example if you only borrow 50% of the value of the property the rent will probably be higher than the interest payable. If you have a lower income and therefore pay a lower tax rate then positively geared may be a good strategy as the tax you will pay on the profit is minimal.
While negative gearing helps to reduce your tax, it does mean that you will be out of pocket each year. You need to be able to maintain this over the long term so that you can gain the benefit of the capital growth.
Are you unsure what your best option is?
If you are unsure which strategy is more effective for your circumstances make sure you speak to one of our tax accountant specialists.
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