Negative Gearing Explained

Image from Tierra Mallorca |

Image source: Tierra Mallorca

The words “negative gearing” are often thrown around – but what do they actually mean and why would you want to negatively gear an investment?

Negative gearing is where you borrow money to invest and the income from the investment is less than the expenses. Investments in shares and some other assets can be negatively geared, but the most common form of negatively geared investment is property.

Here is an example to show what negative gearing means and how it works.

Assume you buy a property and it generates a rental income of $20,000 and expenses paid by you – interest on the mortgage, land tax, insurance, rates, etc, total $24,000. This means you have a rental property loss of $4,000 that can be deducted from your other income. Assuming you earn a salary of $60,000, your tax return will show net income of $56,000, and this is what you will pay tax on. The effect of negative gearing, therefore, is to reduce your income by $4,000 and the tax you save on this loss is tax at your marginal rate – which, on the facts listed above, would be approximately 35%. So the tax you save on the loss of $4,000 is $1,400 (35% of $4,000).

(Two quick points need to be made here. Firstly, it is only the interest on a loan, and not any repayment of principal, that is taken into account in this calculation. Secondly, depreciation and capital allowances can be claimed on some properties, and this involves a tax deduction (and a tax saving) without any cash outlay, but this lies outside the scope of this article.)

In overall terms therefore, you are $2,600 out of pocket- you have $2,600 less cash – because your outgoings on the property are $4,000 more than your income, but your tax saving because of the rental property loss is $1,400.

In essence, this what negative gearing is.

So why would you want to be thousands of dollars out of pocket each year as a result of buying a property?

It makes sense only if the gain you make when you sell the property is greater than the losses you incur each year.

When you sell the property and make a gain, you will pay tax on only half the gain (because of the 50% Capital Gains Tax exemption). The question is whether the real after-tax gain you make is greater than the after-tax losses – in the example above, $2,400 per year.

Note the importance of calculating the real after-tax gain. The time value of money is important – the current value of the gain will be less than the current value of the losses because of inflation (albeit inflation is currently low) and the marginal tax rate on the gain will be high because of the way the tax system works. You will pay tax on the gain in the year you sell the property, and the gain will be added to your other income – meaning in that year you will have a high income and a high marginal tax rate.

Some properties that are negatively geared produce outstanding returns for investors. Others produce low or negative returns. Negative gearing is not automatically good – it depends on the quality of the property. We see many examples of people who do not consider the quality of the property they are buying, but instead are sold on the apparent negative gearing advantages. That can be a recipe for a disaster – or, at least, a very poor investment.

The information contained herein is of a general nature only and is not intended to be relied upon nor is it a substitute for appropriate professional advice. Whilst all care has been taken in the preparation of the material, it is not guaranteed to be accurate. Individual circumstances are different and as such require specific examination. Asparq cannot accept liability for any loss or damage of any kind arising out of the use of or reliance upon all or any part of this material. Additional information may be made available upon request.