Negative gearing refers to a situation where an investor makes a loss on an asset, then deducts that loss from their taxable income. Many property investors in Australia use negative gearing to their advantage, so it’s something you’ll want to get your head around before you start investing.
What is negative gearing?
Gearing is a finance term that refers to borrowing money to invest the costs of doing so against your taxable income. If an an asset is costing more each year, in interest and other expenses, than the income it generates, it is negatively geared. The opposite is true for positive gearing, where your income outweighs your expenses.
With negative gearing in Australia, these losses are generally deductible, reducing taxable income. If an investment property owner is spending more on their property, in interest, maintenance costs and other assorted fees, than they are receiving in rent, the property is negatively geared.
Imagine John, he’s a property investor and buys a residential property for $500,000, with a $450,000 home loan at 5% p.a. His expenses for the first year are as follows:
Interest. In the first year of the loan, John will pay $22,349 in interest, as per the amortisation schedule (calculated using Infochoice’s mortgage calculator).
Property management fees. He hires a property management firm that charges 5% of the rental income, $100 a month or $1200 a year.
Property insurance. He pays $1,200 each year in insurance.
Repairs and maintenance. In his first year, John spends $1,000 on repairs.
His total expenses are $22,349 (interest) + $1,200 (property management) + $1,200 (insurance) + $1,000 (repairs) = $25,749. He gets tenants in immediately who pay $2,000 a month in rent, or $24,000 annually.
Therefore, in this first year, John is making a tax deductible loss of $1,749 on his property. His marginal tax rate is 32.5%, so when he applies this deduction, he saves $568.43.
His after tax loss then becomes only $1,180.57 ($1,749-$568.43). John anticipates the property’s value will go up very quickly, so he is happy to use negative gearing to mitigate these losses in the hope of hefty capital gains down the line.
Negative gearing vs positive gearing
If the rental income from an investment property surpasses all the expenses, interest included, it is known as positively geared. Investors with positively geared properties have an income from the property, taxed at their marginal rate.
If John managed to convince his tenants to pay an increased rent of $2,500 each month ($30,000 annually) his property would be positively geared. He’d made a $6,251 profit each year, or $4,219 after tax.
Properties where the expenses and income are equal are known as neutrally geared.
Why do people negatively gear property?
There are a couple of reasons why negative gearing is such a popular investment strategy in Australia.
Negative gearing allows investors to offset losses from their investment property against their taxable income, reducing their tax bill. Some investors with several properties might be able to use their deductible losses from negatively geared properties to lower their taxable income sufficiently to drop a tax bracket.
As a property investor you can also claim, as part of the tax ledger, depreciation on the dwelling itself (capital works) as well as the fixtures and fittings (plant and equipment).
Capital gains can far outweigh expenses and losses
Investors are often willing to accept short term losses if they expect the property’s value to increase over time. Capital appreciation in Australia tends to be far more lucrative than strong rental returns where across capital cities, rental yield remains quite low.
Investors will often prioritise buying in areas with potential for strong capital growth rather than high rental yield. Provided the property has been owned for more than 12 months, investors can often also get a 50% deduction on capital gains tax when they do decide to sell.
Conversely, the areas with the highest rental yield are often in areas that historically have provided less capital growth. Some areas might have a high rental yield, but very slowly increasing or even declining sale prices.
Consider somewhere like Port Hedland in Western Australia, known for its huge petroleum, iron ore and natural gas deposits. Port Hedland has one of the highest rental yields in Australia, with a huge demand for temporary accommodation as miners move to the town.
As projects finish though, people generally move on, so there’s much less demand for buying. There’s a good chance an investment property in Port Hedland would be positively geared, but long term returns probably would be unspectacular. On the other hand, properties in inner city suburbs are more likely to be negative geared, but there might be strong demand among buyers, meaning significant potential for capital gains.
Is negative gearing bad?
Negative gearing is a bit of a controversial topic. Some people in Australia think interest on investment properties shouldn’t be a tax deductible expense, as in countries like the United Kingdom and the Netherlands. Opponents argue it disproportionately benefits the wealthy, boosting returns for investors and therefore driving up property prices for those looking to buy a home.
Previous election cycles have floated the idea of getting rid of negative gearing and myriad other tax benefits for property investors. This was most notably seen in the Federal Labor 2019 election campaign.
The Australian Council of Social Services (ACOSS) is also among those that have suggested perpetual negative gearing is unfair. In a 2015 report on housing affordability, ACOSS said properties making capital gains each year aren’t truly making a loss, and either capital gains should be taxed annually or losses could not be offset until capital gains were taxed upon the properties sale. Other ideas include only offsetting the losses on one property or to phase it out after a number of years.
The other side of the aisle says allowing these deductions makes property investing more attractive, increasing the supply of rental properties which keeps rates low. It also makes it uniform with share trading, where if you make a loss in the financial year you can claim it against your taxable income.
Many within the property industry are critical of any policy that hurts the earning potential of property investors, arguing this puts upward pressure on rents and the rental supply, because private landlords supply upwards of 90% of the rental stock in Australia. This has only grown over the past 30 years.