What is negative gearing and how does it actually work?

NegativeGearinghomes2How you can use negative gearing to save on your taxes.

Negative gearing offers a range of benefits to investors, but it’s not without risks. Read on to find out how you can reap the benefits of negative gearing.

What is negative gearing?

An investment property is negatively geared if the net rental income (after deducting expenses) is less than the interest on the borrowed funds.

The outcome of a negatively geared property is that a net rental loss arises. For example, you could borrow money to buy an investment property, renovate the property and then cover a range of maintenance costs. At the end of each financial year, you may discover that the annual rental income you generate from your investment is less than the expenses you incurred when purchasing and maintaining the investment.

While this may not be a great result at face value, you can benefit from this loss by offsetting it against the income you earn from other sources. The end result of this is that you will effectively be earning less income which means you'll have less tax to pay at the end of the financial year. As well as the taxation benefits on offer, investors can still make a long-term profit on their investment when the value of the property increases to a point greater than the outlay costs.

While common for property investing, negative gearing can also be used for other financial instruments such as shares and bonds.

ALSO READ: Find out how a home loan can change your investment strategy

ALSO READ: Learn about how negative gearing works and how to invest using it

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What are the investment expenses that you can claim as a deduction?

Generally you can claim a deduction for your expenses associated with the management and maintenance of the property, including the interest you pay on loans. If your asset is negatively geared, you may be able to deduct the full amount of rental expenses against your rental and other income, including your salary and wages.

If you own an investment property there are a wide range of expenses that you can claim as tax deductions. Depending on your circumstances, you may also be able to claim depreciation against the property’s rental income. As a general rule, property investors can claim deductions in three main categories:

  • Revenue deductions. You can claim revenue deductions such as for the interest on the money you borrow as well as ongoing maintenance fees.
  • Capital items. Large items such as a plumbed-in dishwasher in a rental property are subject to depreciation over time and can be claimed over several years.
  • Building allowances. Generally, you can claim for building allowances such as for depreciation over time or for building works.

You can visit the ATO website for an exhaustive list of deductible expenses.

How to calculate negative gearing

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Additional deductible expenses

Negative gearing expenses

  • Body corporate fees
  • Costs associated with borrowing (e.g. stamp duty charges on your loan)
  • The cost of advertising for tenants
  • Insurance
  • Fees and commissions charged by property agents
  • Land tax
  • Repairs and maintenance costs
  • Interest you are charged on your loans and other bank fees
  • Cleaning services
  • Gardening and lawn mowing costs
  • Pest control expenses
  • Council and water rates
  • Capital works costs
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What place does negative gearing have in the Australian market?

negativegearing3 Negative gearing has been a popular strategy for Australian investors for many years.

Investors (and savvy financial planners) are always looking for benefits and breaks come tax time, and negative gearing allows them to take advantage of a short-term loss. Negative gearing isn’t allowed in many other developed markets around the world, with many economists claiming that it inflates house prices.

Statistics from the ATO show that the value of negative gearing tax breaks claimed for investment properties decreased from $13.8 billion to $12 billion between the 2011-12 and 2012-13 financial years. This trend is a reflection of attitudes towards negative gearing which suggest that negative gearing can have a detrimental affect on the Australian property market and the economy as a whole.

A 2015 report from the Australian Council of Social Service (ACOSS) claimed that more than half of the benefit of negative gearing deductions goes to people who earn more than $100,000 a year. These high-income earners represent the top 10% of personal taxpayers, and the report pointed to the fact that negative gearing helps the rich get richer and puts a strain on public revenue. In addition, over 90% of borrowing done by investors is for existing rental properties rather than new ones, leading to rising prices on existing houses and little being done to supply new houses.

Other claims in the report included that negative gearing encourages people to invest with tax avoidance in mind rather than with the aim of achieving the best possible return with the lowest possible level of risk, and that it destabilises the economy by convincing investors to borrow more than they otherwise would.

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Is it a good investment strategy?

NegativeGearingInvestment If you carefully select investments that have capital growth potential, negative gearing can be a sound investment strategy to build assets for your retirement. It’s a strategy used by thousands of Australian investors to achieve the best financial result across a wide range of investments.

Whether or not negative gearing is a good investment strategy for you depends on a range of factors.

First of all, in order to make negative gearing work for you, you’ll need to have a complete understanding of how it works, the deductions you can claim and the need to make a capital gain when you sell your investment in the future. As a general rule, negative gearing is best suited to those investors who have the financial capacity to withstand a drop in the value of their investment.

You’ll also need to be able to cope financially if interest rates rise and you need to manage increased interest repayments on your loan, or if you face untenanted periods. In other words, you’ll need a reliable income and sufficient cash flow to be able to manage when circumstances change.

If you meet these requirements, it may be worth discussing the ins and outs of negative gearing with your financial advisor or tax accountant. However, before you commit to any investment strategy you should be fully aware of all the risks involved – as negative gearing is not without its potential downfalls.

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What are the risks involved with negative gearing?

Just like any investment strategy, negative gearing has risks. Borrowing money to fund an investment is risky in itself, and you should be fully aware of what negative gearing involves before you pursue this strategy. Consider the following risks before you commit to a negative gearing strategy:

  • What if you have a cash flow shortage?
  • What if you can’t find a tenant and the property is left vacant for an extended period?
  • What if the property market takes a dive and you are unable to achieve the capital gain you had planned?
  • What if you are unable to make your loan repayments?
  • What if tax laws change and negative gearing is no longer as financially viable for your unique needs?

However, there are steps you can take to minimise the risks associated with negative gearing. The best way to minimise your investment risk is to do plenty of research when choosing your investment property. Study historical market trends and a range of other factors (the economy, infrastructure in the local area etc) to select a property that is likely to rise in value. Make sure your income is high enough to cover interest repayments and maintain your investment property, even in less-than-ideal circumstances, and have mortgage insurance in place on your investment loan to provide an added level of protection. Speak to the experts such as a financial planner, a tax accountant and a mortgage broker to ensure that you make a sound financial decision.

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