Practically every adult in Australia is familiar with the term “Negative Gearing” and rarely does a week go by without “Negative Gearing” being talked about in the news. However, most Australians do not understand what it is and how it can benefit them if they seek to build wealth through property. Let’s break it down in simple terms.
What Is Negative Gearing?
At its core, negative gearing occurs when the costs of owning an investment property—such as mortgage interest, maintenance, rates and other expenses—exceed the rental income generated from the investment property. Essentially, you’re running your investment property at a loss. While this might sound counterintuitive, there’s a significant silver lining: the Australian tax system allows you to offset this loss against your taxable income.
How Does Negative Gearing Work?
Imagine you own an investment property that brings in $25,000 annually in rental income. However, your expenses for the property (mortgage interest, council rates, insurance, and maintenance) add up to $30,000. This means you’re running at a $5,000 loss for the year.
With negative gearing, you can use that $5,000 loss to reduce your taxable income. For instance, if you earn $90,000 a year, your taxable income would be reduced to $85,000. As a result, you’ll pay less tax, which helps to offset the investment loss.
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Why Would You Buy a Property If It Was Going to Make a Loss (What Are the Benefits of Negative Gearing)?
- Tax Benefits As seen in the example above, negative gearing allows investors to reduce their tax bill, which can make property investment more affordable. This is particularly beneficial for individuals in higher tax brackets, as the tax savings are proportional to their marginal tax rate.
- Not all losses involve negative cash flow One of the deductions that may be claimable for an investment property is depreciation of the property and its fixtures and fittings. In other words, the value ascribed, for accounting purposes, to the wear and tear of the property. This is a non-cash expense that can increase the negative gearing (without impacting monthly cash flow) so is appealing to some investors. Typically, depreciation is significant in new properties and reduces the older a property is (unless recently renovated).
- Long-Term Capital Growth Many property investors are willing to absorb short-term losses because they anticipate long-term capital growth. That is, they expect that over time property values may increase significantly, resulting in a profit when the property is sold.
- Diversification of Income Investment properties can provide a secondary income stream through rental payments. While negatively geared properties may not yield immediate profits, they can diversify your financial portfolio and build wealth over time.
- Wealth Accumulation By holding onto a property in a high-growth area, you can build equity as the property value appreciates. This equity can later be leveraged for further investments or other financial goals.
Is Negative Gearing Right for You?
While negative gearing offers several advantages, it’s not a one-size-fits-all solution. Here are a few things to consider:
- Financial Stability: Can you comfortably cover the shortfall between your expenses and rental income without compromising your lifestyle?
- Long-Term Commitment: Property investment often requires a long-term view. Are you prepared to hold onto the property for several years to see capital growth?
- Market Conditions: Investing in areas with strong growth potential is essential. Conduct thorough research or consult with professionals to identify promising locations.
Potential Risks of Negative Gearing
It’s also important to understand the potential downsides:
- Ongoing Losses: Negative gearing means you’re running at a loss. If property values don’t grow as expected, then you might not realise the profit you had expected.
- Interest Rate Increases: As we have seen since Covid, interest rates can rise which increases your interest expense. That then widens the gap between your rental income and costs and stretches affordability.
- Dependence on Tax Benefits: If the government changes tax laws around negative gearing, it could impact your investment strategy.
A Final Word
Negative gearing can be a powerful tool for building wealth, but it’s not without risks. It’s essential to do your homework, understand your financial position, and seek advice from professionals such as mortgage brokers, financial advisors, and accountants.
By understanding the ins and outs of negative gearing, you can make informed decisions and unlock the potential benefits of property investment. Whether you’re a seasoned investor or just starting out, knowledge is the key to success in building your wealth.
At Hatch Financial Services, we specialise in helping clients navigate the complexities of property investment, ensuring they make informed decisions that align with their financial goals. If you’re considering investing in property or want to learn more about negative gearing, get in touch with us today.
