A well-known and popular investment strategy, negative gearing is primarily associated with real estate. Not only can negative gearing form a part of a wealth creation strategy, but also can deliver long term financial benefits and possible taxation concessions.
In this guide we are going to introduce you to the concept of negative gearing as well as:
- the importance of capital growth
- what you need for negative gearing to work
- what assets can be leveraged for negative gearing
What is Negative Gearing
Negative gearing can be defined as borrowing money to invest into an asset that produces an income that is less than the expenses required to maintain said asset (ie. you are making a loss). Whilst investing in any form of asset is done so with the intention of making money, making a loss is of course never ideal. However, Australian law allows the losses from investment properties to be deducted from your taxable income.
The benefit of leveraging negative gearing to invest in property is the short-term opportunity to reduce your taxable income, but the long-term opportunity to cash in on a property’s long-term capital growth which exceeds the losses accrued during ownership. It’s important to remember that this capital gain is not taxed until the asset is sold – and commonly only half of the gain is taxed provided the asset was owned for longer than 12 months.
A simple example shows how negative gearing works. Let’s assume a client buys $100,000 of property using alternatively no gearing, 40% gearing and 80% gearing. After one year the property increases in value by $10,000. The position is as follows:
|Equity invested||Amount borrowed||Amount invested||Gain||%|
Gearing leverages the investment to increase gains when asset values rise.
But there is a ‘reverse’ gear too. Gearing leverages the investment to increase losses when asset values fall. Let’s assume our client stays in the market with her $110,000 of geared property using alternatively no gearing, 40% gearing and 80% gearing. In the second year the property falls in value by $20,000. The position is as follows:
|Equity invested||Amount borrowed||Amount invested||Gain||%|
Gearing makes everything bigger and faster: the gains and the losses.
Negative Gearing vs Positive Gearing
Positive gearing is where the income from an asset that has been financed by debt exceeds the interest and other holding costs. Whilst quite rare in property investment it is not so unusual in share investing.
Positive gearing may reduce risk.
Positive gearing allows the opportunity to improve cash flow, and therefore the ability to reduce debt, make fresh investments, or both. While the logic of positive cash flow investments is strong, caution needs to be applied. The probability of the expected income occurring should be assessed prior to progressing to leveraging the improved cash flow. Positive cash flow might also mean that relatively few people want to own the asset – which may make future capital returns problematic.
The following is a case study published by MoneySmart which compares negatively and positively geared properties.
Case study: Comparing negatively and positively geared properties
Rod and Karen are brother and sister and both earn around $70,000 per year. They are both thinking about buying an investment property worth $400,000. Interest on an investment loan will be 6% pa, payable on an interest-only basis. Additional property expenses are estimated at $5,000 a year. Rental income is expected to be $500 a week.
Rod will need to borrow the $400,000 needed to buy his investment apartment as he has no savings. Interest on the loan is $2,000 a month, which is tax deductible.
Karen has some money saved so she only needs to borrow $100,000 for a similar apartment. Karen’s interest payment is $500 a month, which is also tax deductible.
|Rod and Karen’s income before buying an investment property||Rod’s negatively geared investment property||Karen’s positively geared investment property|
|Plus rental income||–||$26,000||$26,000|
|Less interest||–||– $24,000||– $ 6,000|
|Less property expenses||–||– $ 5,000||– $ 5,000|
|Tax (Ex Medicare levy)||– $14,297||– $13,322||– $19,172|
- Tax calculations based on 2019 individual tax rates
- Example reflects the interest payable in the first year. Over time this will decrease but so will the tax benefits.
- It does not take into account inflation, increases in rental income or changes to interest rates or income tax rates over time.
- Capital growth is not taken into account as it does not affect income calculations. The same capital gain would be applicable under either scenario.
Karen is positively geared so her income is considerably higher than Rod’s. If Karen had left her money in a savings account earning 5% interest, her after tax income would be the same, however a savings account has no potential for capital gain.
Rod actually has less money in his pocket as most of his rental income is being paid to the bank in interest so he has to cover some of his investment expenses from employment income. He will be hoping a future capital gain will recoup his short-term income losses.
Negative gearing is a popular tax minimisation strategy, but remember, you only reduce your tax if you reduce your income. If you are borrowing to invest, choosing a positively geared investment will increase your income and increase your overall return on investment.
The Importance of Capital Growth in Negative Gearing
As we have seen in the previous examples, the impact of both gains and losses is bigger and faster for geared investments. This only highlights the importance of capital growth for negative gearing to be successful. Negative gearing will make you money if the asset’s long-term capital growth is greater than the loss you make whilst holding/maintaining that asset. The loss needs to take into consideration all costs – from loan interest to property maintenance, rates and so forth.
“Borrowing to buy growth assets, such as shares or property, and using your own cash or equity in your home as a down payment, helps you increase your returns. You make a profit as long as the investment returns (income plus capital gains) are greater than your interest payments. Say you have $10,000 and borrow another $10,000 at 8% interest to buy shares with a dividend yield of 4%. The dividends of $400 cover your interest payments but you stand to make double the profit when you sell the shares because you bought twice as many shares as you could have done with your own money.
Gearing can substantially increase long-term investment returns, but it magnifies the potential risks as well as the potential rewards. If you choose to gear into shares or investment property, invest in a diversified portfolio of high-quality assets that have the best chance of producing solid capital growth over the long term. Never gear to invest in speculative investments, or to avoid tax.”
“Personal Finance for Australians for Dummies” Barbara Drury
When determining the amount to invest, and the extent of gearing, it’s important to look into historical market figures. For example, in the 10 years to December 2016, the long-term average return for residential Australian property was 8.0%. (ASX/Russell). This includes rent, which is typically about 3%, and so the rate of capital growth was around 5%. For the 20 years to December 2016, the overall return for residential property was 10.7% (same source), implying capital growth of around 7% per year.
That said, our advice with property is usually to keep it for the very long term – maybe even forever. And if you never sell a property, you never pay capital gains tax.
Investing in Property or Shares
Negative gearing can be leveraged across a variety of assets, not just for property. The term ‘negative gearing’ simply refers to any situation where the holding cost of a debt-financed investment asset exceeds the income return. Income return is the return that you receive while you continue to hold an investment: it is rent for property and dividends for shares. It is quite possible to experience negative gearing when buying shares, if the dividends are less than the interest and other costs.
The interest incurred on money borrowed to buy shares is also tax deductible, so long as the dividends that are received are taxable. This means that negative gearing still leads to a net tax deduction for the investor, regardless of whether the asset was property or shares.
Interestingly, the long-term performance of each property and share markets in Australia are very similar. However, according to the 2018 Russell/ASX Long Term Investing Report, Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017. When the report arrives each year, we always turn first to the long-term comparison between these two major asset classes. The report compares the ten and twenty-year returns. (This is another reason we like the report – it stresses how holding investments for the long term is the best way to minimise risk). Please don’t read the above results as a reason to sell your shares and buy property! The out-performance of property over shares is not something that we see every year.
The real point is that shares and property achieve similar returns over the long term, and that the long-term performance, which smooths out the ‘bumps’ of individual bad years, is typically good for both investments. It’s not a matter of investing in shares or property for the long term, but rather that you DO invest in at least one of them for the long term.
Contact us for more information on whether negative gearing should be leveraged within your wealth creation strategy.