In Australia, a debate rages about the pros and cons of negative gearing and what the possible benefits and risks that come with it are — for both individuals and the economy as a whole, it’s been a favored strategy for Australian investors for the past decade.
If you’re looking for an overview to assist in achieving your dreams of building an abundant property portfolio, read on to learn what negative gearing is and why it can be a positive investment move.
What is negative gearing?
Negative gearing is a tax strategy in Australia. The term is used to describe an investment if the net income (after subtracting expenses) is less than the interest on the borrowed money.
In other words, an investment is considered negatively geared when the costs of owning it (such as interest on the loan, bank charges, agent fees, maintenance, repairs and capital depreciation) are more than the income it produces (such as rent).
Who is negative gearing for?
Generally, negative gearing is used by property speculators or those with substantial tax obligations as it offers immediate tax benefits. It can also apply to shares, bonds and other investments.
Isn't negative gearing a foolish idea?
On the surface, negative gearing can seem like an impractical way of investing. After all, why would you want the costs of maintaining an investment (such as a property) to cost more than the revenue it is producing?
Therefore, the critical benefit connected with negative gearing is that any loss can be negated against other income earned, such as the person's salary, which in turn reduces their taxable income and, consequently, their payable tax.
What are these tax benefits?
As a strategy, negative gearing can work because it means that a person will be earning less income, resulting in having to pay fewer taxes at the end of the financial year.
These tax benefits are a significant factor for many people as they will be in a position to claim deduction and depreciation against income on the property. There are three main types of deductions available to investors:
• Revenue deductions — Examples are interest on the loan as well as continuous maintenance and repeated charges (council fees, bank fees, body corporate fees, cleaning expenses, gas, and water).
• Capital items — Examples are hot water service or white goods (which are subject to depreciation). However, the investor must declare the expense over a series of years. For this reason, the Taxation Department set depreciation schedules from a few years to more than 15 years.
• Building allowances — Additionally, investors can claim depreciation of capital works, particularly for building and landscaping. The current rate is 2.5% over 40 years.
In short, there is a lengthy list of expenses and charges that you could potentially be able to claim on your tax return.
Besides, even with negative gearing, property investors are still potentially in a position to make a long-term profit on their investment if the value of the property rises to a point larger than the expenditure costs.
What are the risks of negative gearing?
As with any other investment strategy that you may be interested in pursuing, there are risks associated with negative gearing. As a potential investor, you must reflect on the inherent risk that comes with borrowing money for an investment.
This means that you should thoroughly examine your ability to reimburse the shortfall and proceed to maintain the investment loan even if it stops making any resemblance of a return (for example, if the tenants move, or for another unexpected circumstance).
Other cons of this type of investment are that it can drive up prices on existing houses and that it does little to generate new housing supply, which in turn means that it favors those in the high-income bracket and makes it more challenging for first-time home buyers or those in the low-income bracket to have access to the property market.
Before you opt to make any investment, you should speak with a professional financial advisor to discuss which strategies are aligned with your personal circumstances and risk preferences.
Have you ever considered using negative gearing as an investment strategy? Do you think you ever will? Why or why not? Let's start a discussion in the comments below!
AUTHOR BIO: Rob Chaloner is the Founder and Managing Director of Stratton, and is passionate about smarter ways to buy and finance cars. With Stratton, he's working to help Australian buyers disrupt the traditional car buying, financing and insurance markets through smarter products and online services.