How does negative gearing work?

What does this property buzzword mean and how does it actually work?

Here’s what you need to know about negative gearing.

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What is negative gearing?

Gearing simply means borrowing money to buy an asset. Negative gearing can be a tax strategy used by investors and describes when the income (ie, the rent) made from an investment is less than the expenses it incurs, meaning it’s making a loss.

Property investors increase the supply of rental housing and as a result are able to deduct any losses on their properties against any other income such as wages or salary on a tax return, making it more attractive for them to keep their investments.

Negative gearing reduces the need for property investors to depend on tenants’ rent for profit, which helps to keep rents competitive.

Rather, they’re relying on the property’s long-term capital growth at the time that the asset is sold.

And so, the aim for many investors is to limit their losses until the time comes for them to sell – and negative gearing is a good way to do that.

Essentially, negative gearing works if the money an investor makes from a property’s capital growth is greater than the loss they make from the rental shortfall.

How does negative gearing work compared to positive gearing?

Positive gearing is when the income from an asset is more than the costs, which means investors have passive income (which means income that comes in automatically).

While the best long-term investment strategy is positively-geared, there are opportunities around debt recycling that are sometimes used by investors to increase wealth while also increasing debt in the short term.

Many investors attempt to do this by increasing the number of investments that produce passive income, relying on the property market’s historic potential for capital growth over the long term.

Read our full guide on the different kinds of investment gearing and which one could be the right fit for you.

Pros and cons of negative gearing

Benefits of negative gearing

The market value should increase over time

Capital growth is where an asset increases in value over time. For example, if a property is purchased for $500,000 and then sold five years later for $650,000 this $150,000 difference in value is referred to as capital growth.

Historically, property in Australia generally increases in value over the long term. Even with drops in prices from time to time the general trend is that values have increased.

An investor who purchases a property in Australia is generally relying on this trend to continue.

Regular weekly income

Depending on their situation, many investors have a regular income from the rent paid by tenants that covers some of their ongoing costs.

Investors may use this income in various ways, which can include building up equity to purchase more assets or simply paying down the principal amount so that the mortgage is paid off quicker.

Reduces tax liability

Property investors in Australia currently benefit from a reduced tax liability from the federal government.

This is because they are helping to boost the number of available rental properties as well as keeping weekly rental amounts competitive.

Changes to the negative gearing laws can impact how attractive property is as an asset class, which is why the topic attracts so much attention at each election.

Disadvantages of negative gearing

High purchase and transactional costs

When considering investing in the property market it’s useful to compare this asset with other kinds of assets.

Property can attract a different set of costs to other assets such as stocks and bonds, for example maintenance costs, interest fees and transactional costs like stamp duty are paid for property but not stocks.

Property is also one of the most expensive assets many people will buy in their lifetime, equating to hundreds of thousands, or even millions of dollars, so saving a deposit can be a considerable hurdle.

Tenants can leave

Properties on the rental market are susceptible to changes in tenants.

While they’re tenanted they attract regular income, but if they sit empty then there’s no income – which means the investor needs to pay all the costs themselves.

Investors need to ensure the property is attractive to the kind of tenant that will pay rent on time.

Ongoing ownership costs can be high

Unlike other asset classes, property can attract costs around body corporates, council rates, water rates, ongoing maintenance and repairs, insurance, all of which need to be paid upfront.

So while investors may be able to use these to reduce their overall annual tax liability, cash flow issues can arise if these costs aren’t managed properly in the short term.

Becoming a landlord

Becoming a landlord can be a daunting undertaking for some investors.

While most choose to simply hire a property manager, who handles the relationship with the tenants, some choose to go it alone.

From finding a tenant and making sure the tenancy agreement is valid to handling issues, if and when they arise, property managers can reduce the workload for property investors.

Negative gearing case study

An investor’s property, a unit in the Queensland town of Maryborough, costs them $18,000 per year in mortgage interest fees and other charges.

At the same time they are able to charge their tenants around $270 per week in rent, which equates to $14,000 per year.

So, while they are making a loss of $4000 per year, they are able to claim that against their income tax and reduce their overall tax liability.

The other factor to consider is that the property’s market value is also increasing over time. Purchased in 2018 for just under $189,000, it’s currently estimated to be worth around $259,000.

So if the investor were to sell the property right now they’d make a gross profit of around $70,000. However, if they hold onto the property for another few years this is likely to increase even more.

Therefore it’s worthwhile for the investor to continue to own the property as long as holding costs (such as interest fees and maintenance costs) are minimised and capital gains continue to increase over time.

What you need for negative gearing to work

For negative gearing to work, investors need a reliable cash flow to cover pre-tax costs and to earn enough income to meet their loan repayments.

And they also need to be in a position to hold onto the property for long enough for its value to increase to a point whereby the profit made on its sale is greater than its overall costs. 

By allowing prospective investors to deduct any losses they make on their investment property from their taxable income, negative gearing makes it possible for a much larger proportion of the population to buy an investment property, much sooner than they would be able to if they had to rely solely on positive gearing.

And this helps to reduce rental prices, by increasing the amount of rental housing available on the market.

While it’s not the only solution to the rental crunch occurring in many places around Australia right now, which would involve increasing available housing stock negative gearing plays a part in the greater equation.

Before deciding on which gearing strategy works best for you, we’d recommend speaking to a financial advisor, so that you better understand the potential pitfalls and rewards.