Negative GearingNegative gearing, positive gearing, what does it all mean

Negative gearing is a term that’s mentioned quite frequently in the investment pages of financial publications and at most barbecues around Australia. It is the cornerstone of the middle-class Mum and Dad property investors and in certain circles of late it has become a shameful tax evasion strategy. Putting public debate and politics aside, what does negative gearing mean?

Essentially, it’s when the costs associated with running an investment exceed the income the investment generates.

What is positive gearing?

Positive gearing is where the investment generates more income than it costs to hold the investment. (You are making a profit on the return from that investment.)

This means a person who owns a positive geared investment will most likely end up with an income tax bill.

What is negative gearing?

Negative gearing is where the cost of holding the investment is greater than the income it generates.  At present the tax system allows you to offset the losses of the investment against your taxable income, which in turn can reduce your taxable income.

The costs of running an investment property are generally made up of the following:

  • Rates, Council Rates & Water Rates
  • Agents’ Fees, Monthly Management Fees & Advertising Fees
  • Insurances, Building & Landlord Protection Insurance
  • Owners’, Corporation Fees
  • Interest Payments.

On top of the annual running costs, you can also depreciate the asset by claiming 2.5% per annum of the Capital Works for 40 years from new and 10% of the Decline in Value of Depreciating Assets for 10 years from new.

If negative gearing is something you are considering, here are a few questions to ask yourself before you commit your money:

  • What is the realistic growth potential of the investment?
  • What will be the realistic out-of-pocket, after tax cost each year of holding the investment?
  • How long will it take before the investment is positively geared?
  • Would you still cope comfortably if interest rates rose by 3%?
  • Does the potential net (after tax) gain of holding the investment outweigh other investment options (such as paying the money into your superannuation or mortgage)?

Negative and positive gearing examples

As an example, let’s say that you borrow money to buy shares. The interest cost of the investment loan is $10,000 per year and the dividends (income) you receive from the shares is $6,000 per year. In this case, the cost of holding the investment is more than the income the investment provides, so the investment is said to be negatively geared.  On the other hand, if the cost of the loan was $6,000 and the share dividends were $10,000, the investment would be positively geared.

So far it’s all quite simple

Using the example mentioned above, with an investment loss of $4,000, someone on a marginal tax rate of 37% plus Medicare levy could offset that $4,000 against other income and thereby pay less tax than normally incurred.

Often, most investments are usually negatively geared to start with. However negative gearing should not be your main driver for investing in the first place.  The only reason to take a cashflow hit on an investment now is if you’re expecting solid capital or income growth in the future that will more than cancel out those losses of today.  Not only would you want the gains to cancel them out, but to deliver you very healthy profits in the future as compensation for the initial losses.

At the end of the day, remember the most important rule of borrowing for investment.  Always ignore the tax deduction promises and look carefully at the quality of the underlying investment when deciding whether or not it’s worthwhile.

Declan Hanratty  Managing Director

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