Before you delve into the world of investment properties, it helps to look for any tools or strategies that will give your portfolio an edge. As you review your options, there’s one term you’ll likely come across more often than not – ‘negative gearing’.
Mixed opinions circulate about its implications, advantages, and potential pitfalls. In this comprehensive guide, we cut through the noise, giving you clear, actionable insights into negative gearing and help you to decide if it is right for you.
What is Negative Gearing?
Negative gearing refers to when you make an investment using borrowed money, and the costs associated with that investment are higher than the income you’re receiving from it. For example, owing a rental property with a mortgage and other related costs that surpass the net rental income.
You’re essentially running at a net rental loss – so why are countless property investing specialists utilising this strategy?
Here’s the clever part: you can take this loss and use it to reduce your income tax. Investors then count on the negatively geared asset’s value to increase over time, making a profit through a capital gain, even whilst incurring initial losses.
How Does Negative Gearing Work to Reduce Your Taxable Income?
You’re an investor and you’ve decided to purchase income-generating assets – let’s say, rental properties.
You need to borrow money to cover the costs, but the rental income you’re earning from the properties isn’t quite covering the mortgage interest repayments and other rental expenses like ongoing maintenance, property management, and advertising.
There are also expenses like depreciation, which you can directly deduct from your income without having to pay any money, as they are paper expenses to reflect the declining structural value of your property.
Here’s where negative gearing starts to shine.
The loss you’re making can be claimed as a tax deduction against your other income earned. The tax considerations can help offset your losses on your investment possessions.
Commonly used with property investments, this strategy also applies to other investment types, such as shares. It’s a versatile strategy that may serve as a stepping stone for residential property investors, unlocking additional financial strategies and opportunities.
Example
Imagine you’ve invested in a promising piece of real estate, hoping for sizeable capital gains in future years. Let’s say the property’s annual rental income is $25,000, and the yearly expenses (such as interest on your loan, maintenance, and council fees) total $30,000.
So, essentially, you’re operating a negatively geared property at a $5,000 annual loss.
Since negative gearing allows for losses to be deducted from other sources of income, like your main salary, you will be able to offset this $5,000 loss against your taxable income for that year, lowering your tax bill.
Highlighting the Benefits of Negative Gearing for Property Investors
Negatively geared properties provide a unique route to enhancing your personal cash flow.
Quite simply, negative net income yield activates the possibility of using negative gearing as an advantageous financial strategy:
Tax Reduction Benefits
The main benefit of negative gearing lies in its ability to decrease your overall income tax burden. By deducting the losses from your rental property from other income streams, such as your employment or business income, you can effectively reduce your total taxable income, resulting in lower tax payments.
Leverage in Investment
Negative gearing provides a new opportunity for leverage, enabling investors to purchase properties with a minimal initial outlay. The approach allows you to manage a more valuable asset, which can lead to a significant capital gain in the long run.
Prospect of Value Appreciation
Although you might not recoup your costs through rental income in the short run, there’s a potential for your property to increase in value over time. Appreciation can translate into substantial capital gains when you decide to sell.
Portfolio Diversification
Property investment through negative gearing adds variety to your investment portfolio, mitigating risks associated with concentrating all your investments in a single asset category.
Potential Risks of Negative Gearing with an Investment Property
Negative gearing, while a powerful tool for achieving capital gains, also carries its own set of risks.
Financial Strain from Cash Flow Issues
Negative gearing presupposes an increase in property values over time, but until this happens, you have to manage the gap between rental income and expenses. The gap can pose a challenge to your cash flow.
Vulnerability to Interest Rate Hikes
A significant rise in interest rates could increase your mortgage costs, making it more difficult to balance the property expenses against the rental income.
Market Dependency
The effectiveness of negative gearing is heavily reliant on the real estate market’s trends. Should property values plateau or drop, the anticipated capital gains might not materialise (although it would minimise the capital gains tax payable).
Lower Liquidity Compared to Other Assets
Real estate is typically less liquid than other investment forms like stocks or bonds. Selling a property to liquidate your investment can be time-consuming, which could be a concern if you require quick access to your funds.
Impacts of Regulatory Shifts
Changes in government policies, regulations, and tax laws can influence the advantages of negative gearing. Being up-to-date with any modifications in tax and regulatory landscapes is crucial for managing these investments effectively.
Key Takeaways
- Negative gearing is a common strategy used by property investors, where borrowing costs exceed rental income, leading to a taxable loss.
- The choice between negative or positive gearing strategies is a personalised dcision, influenced by individual circumstances, income level, existing debts, risk preferences, and how you wish to pay tax.
- The benefits of negative gearing include potential tax benefits, property leverage, investment diversification, as well as the prospects for a net profit from capital gains, despite initial losses.
- Awareness of risks associated with negative gearing, such as potential market fall, fluctuating interest rates, and vacancy rates, is paramount to a successful strategy. Measures to mitigate these risks include thorough research, property choice, maintaining sufficient income and consulting professionals.
- In the broader scheme of affairs, a suite of measures is required to address affordability and sustainability in property investment for present and future generations.
- Understanding the relationship between taxation and negative gearing can help property investors develop a robust investment strategy.
Learn More on Tax Deductions for Your Return as a Property Investor
If you’re considering property investment or already possess an investment property and think that negative gearing might be the key to opening new wealth-building strategies for you, don’t hesitate to get in touch with our specialist accountants.
Our knowledgeable team at KNS Accountants is ready and excited to guide you through the intricacies of negative gearing. We will discuss possible scenarios and strategies that can help maximise the advantages negative gearing can offer, tailoring the right approach for your unique situation.
Disclaimer
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to contractors and small businesses. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek your own advice for any legal or tax issues raised in your business affairs.
