What is negative gearing?
Negative gearing refers to when investors can claim a tax deduction when their investments make a loss. While negative gearing offers several potential benefits, there are also risks involved.
What do you mean by gearing?
In finance, “gearing” refers to borrowing money to invest in assets. This could include taking out a home loan to buy an investment property, or a loan to buy shares.
Gearing is usually referred to as negative or positive, depending on the cost of the investment compared to the income earned by it. If, during a financial year, an investor spends more money maintaining an asset than they make from it that year, the asset is “negatively geared.” Property-related expenses can include strata levies, council and water rates, and interest charges on their investment mortgage.
On the other hand, if an asset makes the investor more money than they spend on maintaining the asset, then that asset is said to be “positively geared.” For property investors, rental returns count towards the income they receive.
What is negative gearing and how does it work?
An investment property is negatively geared when the expenses incurred on the property are more than the income it generates. This results in negative cash flow, meaning the investment is running at a loss, effectively reducing the investor’s income.
To help investors offset their losses, the Australian Taxation Office (ATO) allows them to claim the net loss on an investment property as a deduction against other income during tax time.
Let's say you earned $20,000 in rental income from a property but paid $30,000 in expenses to maintain it. This results in a net loss of $10,000 that you may be able to claim against your taxable income, lowering the amount of tax you need to pay to the ATO.
While negative gearing could be helpful for investors to offset the losses they make on their investment, it may not be suitable as a long term investment strategy. Running an investment at a loss means you’re losing money, even if you’re able to adjust the loss against your taxable income. Moreover, if the property's value doesn’t appreciate as expected, an investor may suffer a significant loss on a negatively geared property.
What are the benefits of negative gearing?
Negative gearing can be useful to investors who make a loss on their investments through no fault of their own, such as if their expenses are higher or their returns are lower than they expect. The tax deduction can help to soften the blow of this loss, keeping the investor at a lower risk of ending up in financial stress.
Some investors intentionally pursue a negative gearing strategy with their investments to help them minimise their tax. Intentionally running an investment at a loss may sound counterintuitive, even with the tax benefits. But some investors may be less concerned about their income from the investment (e.g. rent or dividends) and more concerned about their investment growing in value over time.
Capital growth could allow an investor to sell their investment at a profit in the future, or to use their equity to help secure finance to expand their investment portfolio. Depending on how much the investment’s value grows, this could potentially more than make up for any income loss in the past.
Selling an investment at a profit generally means being charged capital gains tax (CGT) at tax time, though the amount you’re charged may vary depending on your circumstances. For example, if you’ve owned an investment property for more than 12 months, you may receive a CGT discount.
What are the risks of negative gearing?
Intentionally negative gearing one or more investments can involve a fair amount of risk for an investor.
Firstly, running the investment at a loss means losing money. Less income can be a real problem if the investor’s circumstances were to suddenly change (e.g. they could lose their job, or they may not be able to find tenants for their property), stretching their personal finances.
Secondly, not every investment will appreciate in value over time. Share values can quickly rise, or they could crash hard. Property value growth can stall or even decline in an area if there is a property oversupply, demand for the area declines, or other events slow down the property market, such as a recession or a natural disaster. This could leave an investor with an investment that isn’t making money, and that they also can’t easily sell.
Negative gearing vs positive gearing
Negative gearing and positive gearing are two different strategies for property investing. Here are the key differences between the two approaches:
A property or an investment is said to be negatively geared when the cost of maintaining it is more than the income it generates.
A property or an investment is said to be positively geared when it generates more income than the expenses incurred to maintain it.
The loss incurred in running a negatively geared property can be offset against your taxable income, ultimately reducing your tax liability.
Income generated by a positively geared property gets added to your taxable income.
Results in negative cash flow, as you’re losing money to maintain the property.
Leads to positive cash flow, as the property generates more income than the cost of maintaining it.
Often preferred by investors who want to make a profit through capital gains, without holding on to the property for too long.
Often preferred by investors who want to make a profit through regular income and potential capital gains when the property is eventually sold.
Intentionally pursuing a negative gearing strategy might be risky; you’re relying on the property’s potential to appreciate in future to make a profit.
Positive gearing may be considered a lower-risk strategy; it results in positive cash flow – which means you may be able to profit from the outset.
Is negative gearing worth it?
One reason why negative gearing is part of Australia’s tax system is that it makes it easier for Australians to become investors. However, despite the benefits that negative gearing can provide to investors, there are also risks involved that should be carefully considered before making negative gearing a part of your investment strategy.
Keep in mind that negative gearing strategies often rely on the assumption that the value of the property will increase in the future, and that the investor will eventually be able to sell it for a profit. But there’s no guarantee that would happen. If the value of the property falls, or fails to appreciate as expected, the investor may incur a significant loss. It’s also not guaranteed that the tax benefits of negative gearing will always outweigh the costs of maintaining the property.
You could consider contacting the Australian Taxation Office and/or a qualified tax accountant for more information on how negative gearing could affect your taxes. A qualified financial adviser or a mortgage broker could also provide more personal advice on how negative gearing could affect your investment mortgage decisions.
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Product database updated 04 Mar, 2024