Knowing whether you want to lose now to gain later or vice versa when it comes to property investment means knowing the difference between negative gearing vs positive gearing.
If that entire mouthful seemed like gibberish, be sure to keep reading.
When it comes to buying property, choosing the right investment strategy to suit your short and long-term financial goals is crucial.
Knowing whether you want to employ a positive or negative gearing strategy is an excellent place to start.
What Does “Gearing” Mean?
Gearing is a term used in property investment that refers to taking out a loan to buy a real estate asset.
This property is not bought to be a family home for the owner to occupy but rather to be rented out to generate a rental income.
Whether your rental income will cover the mortgage, interest, insurance, and all the property expenses such as maintenance and rates, will be the deciding factor between positive and negative gearing.
What is Positive Gearing?
Positive gearing is the more traditional and conservative way of making money off investment properties.
It is also known as positive cash flow.
Your investment property generates a positive cash flow if you are generating more money from your rental income than you are spending on mortgage repayments and other relevant expenses.
Positive Gearing to Grow Your Property Portfolio
When your investment property can cover the expenses it generates and still have some change left over, the positive cash flow increases your serviceability and makes you a better borrowing candidate.
Having multiple income streams is attractive to lenders as it acts as a security blanket should something go wrong (such as you getting a pay cut).
Additionally, if you have other investment properties where you might be making a loss, you can use your positive cash flow to supplement those.
Property investors with both negative and positive gearing investment strategies boast a well-balanced property portfolio.
Positive Gearing and Tax
The drawback of generating an additional income is that the Australian Taxation Office (ATO) will come knocking.
The more money you make, the more tax you have to pay. Find out how much here.
But, this is not necessarily a bad thing – making a profit is a good thing!
It’s worth keeping in mind that if you want to invest in property in future: the higher your taxable income, the higher your borrowing capacity.
If you are going to opt for a positive gearing strategy, you’ll want to make sure you are claiming all your tax deductions. This way, you’ll end up reducing your assessable income and pay less tax.
Here are three of the most common tax deduction claims:
1. Interest on Your Loan
The most substantial tax you can claim back is on the interest charged on your loan.
2. Rental Expenses
Many expenses relative to your investment property can be claimed back, such as:
- Advertising costs
- Rental agent fees
- Legal expenses
- Council rates
- Property insurance
- Repairs and maintenance
- Pest control
- Land tax
- Tax advice
- Gardening costs
- Bank corporate fees
- Bank charges
- Accountant costs
Each year the value of a property decreases due to wear and tear. If this property is being used to generate income, you may claim the depreciating assets as a tax deduction.
Things To Consider Before Deciding on a Positive Gearing Strategy
Positively geared properties can be more difficult to find. According to experts Duo Tax, only 40% of properties in Australia are positively geared, so they are in high demand.
High demand means property prices will rise are high. While this is a good thing for vendors the tenant, it’s the opposite for the investor – not only are they paying more for the property, they have to offer competitive rent pricing to lock in tenants.
A higher purchase cost will come hand in hand with a higher deposit. To be positively gearing, you need to be generating more rental income than what you are paying to the bank in mortgage every month. Therefore, you might need to put down a substantial amount as a deposit to do so. But, if you put down 20%, at least you will waive the lenders mortgage insurance fees.
What is Negative Gearing?
Negative gearing is when the property costs, including mortgage, interest and all the expenses, exceed the rental income. Essentially, you make a loss every month as you have to supplement the costs of holding the property.
While you end up paying money out of your own pocket every month, the idea is that that property will grow in value so that you can eventually sell it for a capital gains profit.
A negative gearing strategy usually goes hand-in-hand with the buy and hold strategy.
Negative Gearing Takes Adequate Planning
Make sure that you can afford the monthly out-of-pocket expenses before deciding on a negative gearing strategy.
If push comes to shove, you could be forced to sell the property before your capital has a chance to grow and you could make a substantial loss.
It is not uncommon to offset negative gearing properties with positive ones. If you have one of each in your portfolio, you can use the cash flow property profits to cover the negatively geared one.
Keep in mind that a smaller total income means a smaller borrowing capacity. So you might not be able to borrow the amount you need for further investment properties.
Negative Gearing and Tax
The most significant selling point for negative gearing strategies is that you can claim your losses. Losses are offset against your primary income, so you could potentially move down an income tax bracket.
With negative gearing, you’re also allowed to claim the rental property tax deductions mentioned above.
Fortunately, if you owned that property for more than 12 months before selling it, you could be eligible to claim a 50% concession.
Negative Gearing as an Investment Strategy
Although it is common to use negative gearing as an investment strategy to reduce tax, tax deductions should not be the main reason for purchasing investment properties.
The key investment strategy with a negatively gearing property should be a long-term investment that results in capital gains.
While positive gearing sounds good on paper, it’s always worth considering all options before making substantial financial decisions. Especially if the property doesn’t offer substantial growth.
Finding a property that you can rent out for substantially higher than the mortgage repayments is not easy. And when you do, selling that property in a few years might prove to be
challenging feat as these properties generally do not offer good capital growth..
On the other hand, employing a negative gearing investment strategy can be beneficial in the long run – only if you can afford the ongoing losses until such a point when markets are favourable, and you can sell with a profit.
At the end of the day, cash flow is what keeps you in the market. Capital growth is crucial for one day when you want to sell, retract from the market and retire with your wealth.
While there is a notable difference between negative and positive gearing, the best choice is likely a combination of the two.
Contact a mortgage broker today to set up a free consultation. We will do the research and provide multiple options for you to choose from and advise you on which is best suited to you and your personal financial situation and future goals.
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 property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.