At its core, negative gearing occurs when the costs of owning an investment property exceed the income generated from that property. You can use this financial loss to reduce your taxable income under the Australian tax system.
In this guide, AusFirst Lending Group delves into the intricacies of negative gearing, including the potential tax benefits and risks involved. By gaining a clear understanding of the strategy, you can make informed decisions in using it as part of your property investment journey.
What Is Negative Gearing, and How Does It Work with Investment Properties?
Negative gearing is a term often used in property investment to describe a situation where the expenses that come with owning an investment property, such as interest on the mortgage, maintenance costs, and property management fees, exceed the income generated from that property (e.g., rental income). This scenario results in a financial loss. In Australia, this loss can be used to offset other income, such as your salary, which reduces your overall taxable income.
Suppose you own a rental property that earns $30,000 in rental income each year. However, the total costs of owning and maintaining the property, including interest on your loan, amount to $37,000 annually. This means you are incurring a loss of $7,000 each year. Under the negative gearing strategy, you can use this $7,000 loss to reduce your taxable income, thus lowering the amount of tax you need to pay.
What Is the Relationship Between Negative Gearing and Capital Gains?
While negative gearing provides short-term advantages, such as immediate tax benefits that can help you manage the ongoing costs of holding the property, the long-term financial benefits – which are contingent upon the property’s market performance – may be realised if you eventually sell the property for a capital gain.
Capital Gain
A capital gain is generated when you sell an asset, such as an investment property, for more than you originally paid for it. If the property appreciates in value over time, the eventual sale can provide you with a substantial financial return. This potential for long-term gain is often seen as the ultimate reward for enduring the short-term losses associated with negative gearing.
Capital Gains Tax
When you sell the property, you must pay capital gains tax (CGT) on the profit. However, in Australia, if you hold the property for more than 12 months, you may qualify for a CGT discount, meaning only 50% of the capital gain is factored into your taxable income. This discount can significantly reduce the tax payable on your capital gain, especially when combined with the ongoing tax benefits of negative gearing during the ownership period. It is important to note, however, that the CGT discount primarily applies to individual investors and some trusts, and not to companies.
What Are the Risks and Considerations Associated with Negative Gearing?
While negative gearing may offer tax benefits, it’s crucial to be aware of the potential risks and challenges involved:
- Cash Flow Pressure: One of the primary risks is the ongoing cash flow burden. You need to cover the shortfall between your rental income and your expenses, including mortgage repayments, maintenance, and other property-related costs. If your property remains vacant or if unexpected repairs arise, this cash flow pressure could increase, potentially leading to financial strain.
- Property Value Fluctuations: Another consideration is the risk of property value fluctuations. If the property market declines, the value of your investment might not appreciate as expected. This could affect your long-term strategy, especially if you’re relying on capital growth to offset your initial losses.
- Interest Rate Increases: If interest rates rise, your borrowing costs will also increase, further widening the gap between your rental income and expenses. This could lead to a larger financial burden, particularly if you’ve agreed with tenants not to raise rents for a certain period.
How Can You Manage the Risks of Negative Gearing?
Proactively managing the risks associated with negative gearing is key to maintaining an investment strategy that’s sustainable and aligned with your financial goals. Below are some practical tips you can apply:
- Choose Your Investment Property Wisely: Selecting the right property is crucial. Look for properties located in areas with strong rental demand and close to major amenities, as this can help minimise the risk of prolonged vacancies. Also, a well-chosen property is more likely to attract and retain tenants, reducing your financial burden.
- Maintain a Healthy Cash Flow: Proper cash flow management is key to handling the ongoing costs of a negatively geared property. Ensure you have sufficient income or savings to cover expenses, especially when the property is vacant or requires significant repairs. Planning for these scenarios in advance can prevent unexpected financial strain.
- Protect Yourself with Insurance: Adequate insurance is vital for safeguarding your investment. Consider landlord insurance to cover rental income loss and property insurance for potential damages. Additionally, personal income protection insurance can be a safety net in case your circumstances change, such as job loss or illness, which could impact your ability to meet financial obligations.
- Regularly Review Your Property Investment Strategy: The property market and your personal financial situation can change over time, so it’s important to regularly reassess whether negative gearing continues to be the best strategy for you. Be prepared to adjust your approach as needed, possibly shifting towards positive gearing or exploring other investment options.
Is Negative Gearing Right for You?
You can determine if negative gearing is a suitable approach for your investment property portfolio by considering the following:
- Personal Financial Assessment: Evaluate your current financial situation, including your disposable income and risk tolerance. As mentioned, negative gearing involves covering the shortfall between rental income and expenses. Therefore, you need to be sure you can comfortably manage this ongoing commitment without putting your financial stability at risk.
- Consulting Professionals: Speak with a mortgage broker, financial advisor, or tax professional. They can provide personalised guidance based on your circumstances and help you assess whether negative gearing aligns with your overall property investment strategy and long-term financial goals.
Conclusion
Negative gearing can be a valuable tool for Australian property investors seeking long-term capital gains, even if it involves short-term financial losses. The strategy offers significant tax benefits, particularly through offsetting losses against other income, and it may lead to significant capital gains when the property is eventually sold. However, it’s crucial to be mindful of the associated risks, including cash flow pressure, property value fluctuations, and potential interest rate increases.
Before committing to negative gearing as part of your property investment strategy, it’s essential to thoroughly research and understand how it works. We highly encourage seeking professional advice to ensure your investment strategy not only aligns with your financial goals but also maximises your potential returns while mitigating risks.
FAQs
Negative gearing occurs when the investment property costs – such as mortgage interest, maintenance, and other expenses – exceed the income generated from it, typically in the form of rent. The resulting financial loss can be deducted from your other taxable income, effectively reducing your tax bill. It's a strategy commonly used by property investors in Australia to minimise tax liabilities while holding onto a potentially appreciating asset.
The primary tax benefit of negative gearing is the ability to deduct the net rental loss from your other taxable income, thereby reducing your overall tax liability. Additionally, when you eventually sell the property, and you've held it for more than 12 months, you may be entitled to the capital gains tax (CGT) discount, where only 50% of the capital gain is taxable if you are an individual.
Negative gearing occurs when your investment costs exceed the income it generates, leading to a loss that can be used for tax deductions. Conversely, positive gearing happens when the income from your investment exceeds the costs, resulting in a profit that is added to your taxable income.
Yes. Over time, a negatively geared property can become positively geared as rental income increases and mortgage costs potentially decrease. This shift can occur as the loan balance is paid down or if rents rise faster than expenses, eventually leading to the property generating a profit rather than a loss.
The risks of negative gearing include ongoing financial losses, reliance on future property value appreciation, and the potential for increased costs due to interest rate hikes or unexpected property expenses. Additionally, the strategy can lead to significant financial strain if the property market declines or if you experience prolonged vacancies.
Negative gearing is generally more suitable for high-income earners who can absorb short-term financial losses and are focused on long-term capital growth. It's important to consult a financial adviser to determine whether this strategy aligns with your financial goals and the level of risk you're comfortable with.
