What is Negative Gearing? And How Does It Work?

What is Negative Gearing?

After all the talk and speculation about a possible negative gearing reform by the ALP (Australian Labor Party) during the 2019 election campaign, people may have found themselves asking…

What Exactly Is Negative Gearing?

When it comes to property investment, negative graring means that the rental income earned from the property is less than what it costs to cover the expenses involved with owning the property.

In short, the mortgage repayments required for the property exceed the rental income generated from renting the property out.

That’s negative gearing.

So in short, negative gearing simply means the investor is making a loss on the property.

Negative gearing seems counter intuitive to investing…

That’s because it is.

Then why do people choose negative gearing?

Tax benefits.

You see, under current Australian law, investors can deduct any losses they make on the negatively geared property against their taxable income.

Ok, but negative gearing means they’re losing money?

In the short term yes, but providing the property market is on the upswing, then no – they can actually end up making a lot of money.

How so?

Because investors that negatively gear property are usually looking at it from a capital growth perspective, not an income generating perspective.

They’re banking on the property’s future value, not today’s value.

And by subsidising the property’s losses against their taxable income helps make this a reality.

This is also where interest only loans also come into play.

As the name suggests, interest only loans means there’s no principal (the component to the loan that helps pay down the actual cost of a property) attached to the mortgage to be paid.

This helps investors with interest only loans keep their mortgage repayments to a minimum, which in turn helps free up their cash flow (that would have otherwise gone to paying the principal) for other necessities like fees, bills, repairs and maintenance.

Why does the government support negative gearing?

Because it helps to provide more housing for rental accommodation.

Not everyone can or wants to buy a home but everyone still needs a place to live.

It’s also worth noting that it helps with rental prices.

The more availability of properties on the market for rent means the more renters have to choose from.

When renters have more to choose from, landlords have to be more competitive with the asking rent to secure a tenant.

Having more properties on the market available for rent helps keep rental market pricing in check by way of basic supply and demand.

So they usually make a loss on the rental, which means it then also costs them additional money to service the mortgage all while hoping to sell in the future for a profit?

Provided they have the capabilities to ride the market waves while continually making the minimum repayments to maintain and hold the property, yes.

Let’s give an example to help highlight the idea.

An investor buys a property for $880,000.

To buy the property they pay the 10% deposit, which is $80,000, and then take out a $800,000 loan with an interest rate of 5%.

This would make the annual interest payable for the loan $40,000.

The weekly rent charged is $570 – which over the year works out to be a total of $29,640 in rental income.

$40,000 (total yearly mortgage repayments)
– $29,640 (total yearly rental income)
————–
= – $10,360 (rental shortfall)

As we can see, the yearly mortgage repayments are $40,000 but the rental income is only $29,640.

This leaves the investor with a rental shortfall of $10,360.

This means that the investor has recorded a loss on their property – effectively making the property a negatively geared investment.

However, the benefit to the investor is that under current Australian law they can offset that $10,360 loss against their taxable income.

This means their income would be reduced by $10,360 – resulting in a lower tax payable.

Ok so, how does the capital growth side of things work with negative gearing?

Capital growth is the most important aspect to negative gearing.

Without it, no value or equity is created and in turn, the concept of negative gearing doesn’t work.

Let’s give another example to help highlight the idea.

Let’s say the investor has held the property for 2 years.

And in that 2 years the property value has grown by 20% – making the property now worth $1,056,000.

$880,000 (purchase price)
+ $176,000 (20% capital growth)
————–
= $1,056,000 (new property value)

So after 2 years, the property has grown in value by $176,000.

While the whole $176,000 sum looks good, it’s best not to forget that the investor was recording losses of interest repayments they had to make out of their own pocket to the tune of $10,360 a year.

Over a 2 year period the interest paid was $20,720 (plus whatever holding costs the investor incurred over that 2 year period – again, things like fees, bills, repairs and maintenance).

However, for the sake of simplicity, lets ignore additional holding costs for these examples.

So,

$176,000 (capital growth)
– $20,720 (self funded interest repayments)
————–
= + $155,280 (net capital growth)

This means that even though the investor has paid out $20,720 in interest and their property is still negatively geared, if the investor was to sell for the property’s 20% increase in value, they would be $155,280 richer.

If the investor were to sell however, it’s worth noting that they would still be subject to additional fees and taxes after the property has been sold.

But nonetheless, in this example, they would still be in a much better financial position then before they originally purchased the investment property.

This is the power of negative gearing in a strong or “bull” market.

 

Now for the opposite end of the spectrum.

Lets say the investor has held the property for 2 years and bought at the peak of the market.

In that 2 year period the property value dropped by 5% in the first year and then dropped another 5% the next year, taking the overall net loss in value over that 2 year period to 10%.

This means that not only has the property lost 10% in value, but the investor has also lost their $20,720 in self funded interest repayments over that 2 year period.

So

$44,000 (10% loss in property value)
– $20,720 (self funded interest repayments over 2 years)
————–
= – $64,720 (net loss)

Not to mention the fact that the declining property value has also put the investor into negative equity AND no other costs and expenses related to property ownership have been factored into the workings.

Worse yet, the investor will still have to keep making repayments on the full loan even though the property is worth less than what was paid for it.

As you can see from above, the investor has to play serious catch up with something that is also unfortunately beyond their control – the market.

This is sometimes just a part of property investment.

 

Check out our Complete Kitchen Renovation Guide

This is also why the more you know, the better off you will be – especially when it comes to property investment.

Side note: When it comes to property investment, it is absolutely crucial that you know exactly what you’re doing.

Yes there are instances where people have got “lucky” and just bought at the “right time”, but remember, when it comes to spending large amounts of money, it’s always best to never leave anything to chance or luck and instead make your decisions based off of statistics and facts or at the very least, reliable advice.

You have to be able to ride the waves and above all else, find a way to service the mortgage to get you through those tough times.

This is the cost of property investment – otherwise known as holding costs.

To come out of this situation on top, the investor has to be able to hold the property for long enough to see an increase in property value that surpasses what it has already cost up to that point in time to keep and then also sell.

That’s where negative gearing can get real tricky.

It can work extremely well in “bull” (upwards) markets but can really put investors behind in “bear” (downwards) markets.

As you may be able to tell, for negative gearing to successfully benefit the property investor, the long term capital growth must be greater than the losses sustained to hold and then ultimately sell the property for a profit.

How do you increase capital growth?

There are a few things you can do to increase capital growth however the main proponent to capital growth is beyond your control – time.

This is why knowing what you’re doing and having sufficient funds to service debt and handle costs for long periods of time are paramount to correctly investing in property using negative gearing.

Is negative gearing right for me?

Negative gearing is just one of a number of property investment strategies that investors use to help increase their wealth and build their property portfolio.

But as you can see things can still go wrong.

We recommend speaking with a properly qualified financial adviser that will help you better understand what will work best for you and your individual requirements.

Conclusion on negative gearing

Speak with your financial advisor about the best and most suitable option for you.

Leave a Reply

Your email address will not be published. Required fields are marked *