Negative gearing is a form of leveraged speculation (investment) in which a speculator borrows money to buy an asset (i.e. property or shares), but the income by that asset (i.e. rent & dividends) does not cover the interest on the loan and other costs (i.e. rental costs such as council rates, maintenance of the property etc).

Negative Gearing creates a tax loss which then offsets against other taxable income, which in turn reduces the amount of tax that is payable. This essentially means that you are using the tax savings to partly finance your asset purchase.

However a negative gearing strategy should not be solely used for tax advantages as it is important that the main purpose of buying the asset is because the asset is a sound investment. It is important to remember that you must have the cash flow to cover the losses in a negative gearing strategy.

A negative gearing strategy can only make a profit if the asset rises  sufficiently in price that the capital gain is more than the sum of the ongoing loses over the life of the investment. So you basically will accept a loss in income in the short term because you believe you will be more than compensated for by a capital gain over the longer term.

Before proceeding with this type of strategy, we strongly suggest you contact ProAcct.

Example of how Negative Gearing Works

Kate, a property investor, buys a unit for $300,000, putting in $50,000 of her own money and borrowing the remaining $250,000. The interest of 7% each year is $17,500 and the weekly rent is $300 or $15,600 a year.

Ongoing costs including rates, water, insurance, maintenance and depreciation allowance are $2600 each year. After expenses, income for the year will be $13,000 ($15,600 minus $2600), equivalent to a net rental yield of 4.3%. However, annual interest repayments are $17,500, so she has actually lost $4500 during the year ($17,500 minus $13,000 = $4500).

In this example, the investor can reduce the tax liability on her other assessable income by the investment property’s loss of $4500. If the investor is on the highest marginal tax rate of 46.5% (including the Medicare levy) this tax deduction would have the ultimate effect of reducing the real loss on the property from $4500 to $2408 ($4500 x 46.5% = $2092; $4500-$2092 = $2408). This is a good saving.

If an investor is on a lower rate of tax of 31.5% (including Medicare levy) the after-tax loss on the investment would be reduced from $4500 to $3083 ($4500 x 31.5% = $1417; $4500 - $1417 = $3083). The saving is still quite attractive.

As mentioned, most people accept a loss in income because they believe it will be more than compensated for by a Capital Gain down the track. However, you need the financial flexibility to fund a cash-flow deficit while the property’s Gain accrues. You don’t want to get 18 months into a property investment to find the cash deficit is intolerable.

The calculations are helped by the fact that long-held capital gains are only half assessable. In addition to the simple income deficit, based on the excess of loan interest over rental yield, the investor also needs to be compensated for what they would have earned if they had simply put their money in the bank.

If they deposited the $50,000 into a bank term deposit at 6% and paid tax they would earn $1605 net. So the investor needs a net capital gain of $4013 ($2408+$1,605 = $4013). For the 46.5% tax payer to net a gain of $4013, the property needs to appreciate by $5228 (4013 divided by (0.5 x 46.5%)). This is equivalent to an appreciation of 1.7%. For the 31.5% tax payer the similar calculation gives 2.1%. What does this mean?

Well, if the property market is flat or only slightly positive, the strategy is no better than putting the deposit in the bank. But if property is appreciating healthily the strategy is sound. Over the long term property prices have tended to stay a little ahead of inflation, which the Reserve Bank strives to keep in the zone of 2%-3%. So normally you could count on enough price appreciation to make it work.