Barely a day goes by without some investor or member of the media bringing up negative gearing. But what does it mean exactly?
In investing, gearing is simply borrowing money to buy a property. But the reason you hear so much about it is because the government’s current gearing policies can have a big impact on how attractive the property market appears to investors, which in turn, can have a big impact on everything from the amount of housing on the leasing market to the weekly rent that a property is fetching.
Here’s the fundamentals you need to know about the three types of gearing: negative, neutral and positive.
Negative gearing is when you borrow money to invest into a property and the rental income you make is less than your expenses, meaning that at the end of the financial year you have made a loss.
Typically people look to invest in properties to make money, and so making a loss isn't ideal. But Australian law also allows investors to deduct any losses they incur through an investment property from their taxable income, which makes it far easier for people to invest in the property market because it vastly increases the number of properties that you could purchase. This is the principal benefit of negative gearing – and one that often leads to an increase in rental housing supply.
A majority of investors who buy properties don’t typically expect to make money on the rent. Instead, they buy properties with the intention capitalising a property’s long-term growth. In other words, they buy a property with the hope that the value will eventually increase well beyond all the buying and holding costs to be able to sell and realise a profit.
Therefore the aim for many investors is to limit their losses until the time comes for them to sell the property – and negative gearing is a good way to do that. However, negative gearing only works if the money an investor makes from a property’s capital growth is greater than the losses they incur from the rental shortfall.
Neutral gearing is when you borrow money to invest into into a property and the rental income you make is equal to your expenses.
This means that you are essentially breaking even on your investment and cannot deduct any losses from your taxable income.
Positive gearing is when you borrow money to invest into into a property and the rental income you make is more than your expenses.
This means that you would be earning a consistent weekly income from your investment property, and will also make a capital gain from the sale of the property if property values continue to increase over the life of your ownership.
Of course, because earning income from your property, you won’t be able to make any deductions from your taxable income and you will actually have to pay tax on the income from your investment property, and will be subject being taxed at your marginal tax rate. However, as an added bonus you could use your surplus income to reduce the size of your loan on either your principal place of residence or on the investment property.
Ultimately, positive gearing is the best option for investors, but high competition among investors means that it’s not always possible to increase rents to a level that allows them to earn a constant income on their investment, or find properties that are positively geared from the get go.
Just because you buy a negatively geared property, that doesn’t mean it can’t eventually move through to neutral and then positive geared territory. As time goes by and both rents and capital values increase, it is quite normal for a property to end up as a positively geared investment.
Luke Jorgensen - Lush Property
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