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Negative gearing and positive gearing - what does it all mean for your property investment?

Metricon

Cash flow. Capital gain. Depreciation. Shortfall. Capital growth.

There’s a lot of lingo to interpret for budding property investors and future real estate tycoons.

Two of the most common terms are negative gearing and positive gearing. If you’re new to the world of property investment, you may be wondering what these terms mean, or maybe you’re just wanting to learn a little more about them so you can plan an investment strategy that’s right for you.

We talked to Managing Director of Mortgage Advice Bureau Darren Cantor who explains what negative gearing and positive gearing are, the pros and cons of the two investment strategies and what to consider when deciding on the investment strategy that’s right for your financial situation.

What is negative and positive gearing?

In simple terms, if a property is negatively geared, it means that the cost to maintain the property (e.g. mortgage repayments and maintenance costs) exceeds the money you earn from it (rental income). For example, if your property incurs $30,000 of expenses per year but you only received $25,000 in rent, your property is negatively geared.

On the flip side, if the cost of maintaining your property is less than your income, the property is positively geared.

Darren explains that negative gearing and positive gearing are investment strategies used for a property you plan to rent, not live in.

“If you’re living in the property it becomes your principal place of residence, and therefore it’s not an investment and is no longer tax deductible,” says Darren.

The pros and cons of negative gearing

The main benefits of negative gearing are associated with tax benefits, and Darren says many people choose to invest in property with a distinct purpose to run at a loss so they can reduce their taxable income.

“Say your investment runs at a loss of $10,000 per year and you earn $100,000 per year, you will be assessed on an income of $90,000, not $100,000.”

“You’re gaining the benefit because while you’ve made a loss on your property, you’ve offset part of that loss by reducing the amount of tax you have to pay,” says Darren.

Another tax benefit of negative gearing is the capital gains tax concession that investors are entitled to.

“If you hold the property longer than 12 months, you receive a 50 per cent concession on the capital gains. So not only do you get a benefit on income tax but when you sell the property, you’ll get a 50 per cent tax reduction on the gains (if any) which is another positive outcome of negative gearing,” says Darren.

One of the downfalls of negative gearing is that if you don’t have a reliable income, then you risk not being able to support your negatively geared property.

“A negative gearing investment strategy is really only suited to people who have a reliable income stream and can cover the loss that their property runs at until they sell.”

Darren says another problem people can run into is that their property does not increase in value.

“There is a long-held belief that property in Australia always goes up in value, and for a long period of time we’ve seen that. But we’ve recently seen a drop in property prices as the market has corrected itself.”

“Negative gearing really only works in areas where property prices are rising, otherwise if you run the property at a loss and also sell at a loss, the negative gearing strategy has not been successful.”

The pros and cons of positive gearing

The greatest benefit of positive gearing is that you are making an income, which means you are less reliant on the capital gains and are not waiting until you sell to potentially make money.

Darren says that earning an income from your investment opens other opportunities such as owning the property sooner and having the capital to undertake renovations or improvements to add value to the property.

“If your property is positively geared, you can potentially use the income to reduce the debt and pay off the property faster. Many investment properties are on interest-only payments, but you can increase your asset wealth by paying down the debt.”

“You could also consider making improvements to the dwelling/s to add value and strengthen your position when you sell the property. There are taxation guidelines around what constitutes an improvement, maintenance and renovation, and what costs the Australian Taxation Office see as acceptable, so it’s best to understand these before doing any work.”

Darren points out that the only thing that could really be considered a downfall of positive gearing is that you will be taxed on the income you make from the property, potentially altering your tax bracket and tax bill.

“Some may see this as a bad thing, but if you are getting taxed, you’re earning money, and that may not be considered a downfall,” says Darren.

Negative gearing vs. positive gearing - which is best?

There is no science when deciding whether purchasing an investment that will be negatively or positively geared is best for you, it really just depends on what you want to achieve, your situation and how much risk you want to take on. Darren reminds us there is risk associated with any investment.

“Interest rates, tax concessions and property values can all change at any time while you hold an investment property,” says Darren.

“My advice is to assess the market and your circumstance and think carefully about how these could change over time. While your property may be negatively geared, to begin with, it could become cost-neutral or positively geared as the market moves and interest rates come down. Consider balancing your portfolio to balance out the risk of your investments.”

Should you seek professional advice before investing?

Buying an investment property may be one of the most significant purchases you make in your life, so it’s important to get advice and understand your investment strategy before making any decisions. Darren says the first and most important thing to think about is why you are purchasing an investment property.

“A big mistake that a lot of people make is they invest their money before they work out what their investment structure and strategy will be. There are a lot of costs associated with an investment property, not just mortgage and interest repayments, and you need to think about things property management fees, how you’ll pay maintenance costs, how you’ll cope if the property is vacant for a period of time. You need to think long-term, not just short-term.”

“Sit down with a trusted adviser, whether a financial adviser or mortgage broker, and work out what you are trying to achieve. Chat about what kind of investment loan or home loan lenders might be able to give you, as well as the potential loan repayments and interest payments. Then understand where you are at now and could be in the future – ask yourself some ‘what if’ scenarios. Once you can tick all the boxes, then you can go forward in confidence,” says Darren.

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Head to the ATO website to find more information about owning a rental property and the potential tax deductions you could claim each financial year.

Disclaimer: While we've tried to be as helpful as possible, this article should not be taken as professional financial advice. It contains general information only, and you should seek out independent, professional advice before making any financial decisions. Metricon is an Australian company who builds homes in Sydney, Melbourne, Brisbane and Adelaide.