For readers of Your Investment Property Magazine, understanding how it operates under the tax law, how it interacts with capital gains tax (CGT), and when it genuinely makes financial sense is critical before committing to a leveraged investment strategy.
As tax practitioners regularly observe when advising property investors, misunderstandings around negative gearing often stem from confusing tax outcomes with cash flow realities.
What is negative gearing?
At its simplest, negative gearing occurs when the income generated by an investment property is less than the expenses incurred in holding it. The shortfall (“net rental loss”) can generally be deducted against the investor’s other assessable income, such as salary or business income.
Under the Australian income tax system, rental income is included in assessable income pursuant to s 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), while allowable deductions are claimed under s 8-1 (general deduction provision) and specific provisions such as:
- Interest on investment loans (generally deductible under s 8-1 where the borrowed funds are used to produce assessable income)
- Capital works deductions (Division 43 ITAA 1997)
- Depreciation of plant and equipment (Division 40 ITAA 1997, subject to post-9 May 2017 restrictions on second-hand assets)
- Other holding costs (rates, insurance, agent fees, repairs and maintenance)
If total deductions exceed rental income, the resulting net loss reduces the investor’s taxable income for the year.
In practice, H&R Block advisers often see investors surprised by how mechanical this calculation is and how little discretion remains once the numbers are applied correctly.
How negative gearing works in practice
Consider a simple example:
Sarah purchases an investment property for $800,000, funded by a $640,000 loan at 6.5% interest. Her annual rental income is $30,000.
Her annual expenses are:
- Interest – $41,600
- Rates and insurance – $4,000
- Property management fees – $2,400
- Repairs – $2,000
- Depreciation and capital works – $5,000
Total expenses: $55,000
Net rental position: $30,000 income - $55,000 expenses = -$25,000 (net rental loss)
If Sarah earns $170,000 in salary, the $25,000 rental loss reduces her taxable income to $145,000.
Assuming a marginal tax rate of 37% plus 2% Medicare levy (39%), the tax saving is:
$25,000 × 39% = $9,750
Her after-tax cash shortfall is therefore:
$25,000 - $9,750 = $15,250
In other words, negative gearing reduces the cost of holding the property, but it does not eliminate it.
Sarah is still out of pocket each year, albeit by less than the pre-tax loss. This distinction is one advisers consistently reinforce when reviewing investor tax returns.
The role of capital growth
The fundamental premise behind negative gearing is that capital growth will more than compensate for the ongoing cash losses.
If Sarah’s property increases in value by 6% per year, the $800,000 property grows by $48,000 in year one. On paper, she has gained significantly more in capital growth than her after-tax cash loss of $15,250.
However, capital growth is unrealised until sale. If the property is sold after holding for more than 12 months, Sarah may be eligible for the 50% CGT discount under Division 115 of the ITAA 1997 (assuming she is an individual and not carrying on a property trading business).
For example, if she sells after five years for $1,050,000, her capital gain (ignoring selling costs and adjustments) would be $250,000. After applying the 50% discount, only $125,000 is included in assessable income.
At a 39% marginal rate, the CGT would be approximately $48,750, significantly lower than if the full gain were taxed.
The combination of deductible rental losses during ownership and concessional CGT treatment on sale is what makes negative gearing attractive in a rising market.
Cash flow vs tax benefits
A key misconception is that negative gearing is a strategy to “get money back from the ATO”. In reality, tax deductions simply reduce taxable income. You are still losing cash.
Using Sarah’s example, she spends $25,000 more than she receives in rent. The tax system subsidises 39% of that loss, but she still bears 61%. This is a point frequently raised in client discussions when reviewing investment property outcomes alongside annual tax obligations.
If capital growth stalls or property values decline, the strategy can quickly become financially painful. Negative gearing works best when:
- The investor has sufficient income to absorb the loss
- Long-term capital growth prospects are strong
- The investor can comfortably service the debt during periods of higher interest rates or vacancy
Interest rates and risk
Interest is typically the largest deductible expense. When rates rise, the size of the rental loss often increases, placing greater strain on cash flow, a scenario tax advisers at H&R Block regularly see when reviewing property portfolios during higher interest rate cycles.
For highly leveraged investors, a rise from 4% to 7% interest can dramatically increase annual holding costs. In some cases, previously neutral or slightly negative properties can become significantly cash flow negative.
Investors should stress-test their borrowing capacity and cash reserves. Tax benefits should not be relied upon to justify marginal servicing positions.
When negative gearing makes financial sense
Negative gearing may make sense where:
1. You are in a higher marginal tax bracket
The higher your marginal tax rate, the greater the value of each dollar of deduction. For example, a taxpayer at the top marginal rate (45% plus Medicare levy) receives significantly more benefit per dollar of loss than someone on a 19% rate.
However, this does not automatically make it sensible; it simply improves the after-tax cost profile.
2. The property has strong long-term fundamentals
Location, infrastructure investment, population growth, and scarcity drive long-term capital appreciation. Negative gearing without a credible growth thesis is speculation rather than strategy.
3. You have a long investment horizon
Property markets can experience flat or declining periods. Investors with short timeframes are more exposed to volatility and transaction costs (stamp duty, agent fees, legal costs), which can erode returns.
4. You maintain liquidity buffers
Unexpected repairs, prolonged vacancy, or personal income disruption can quickly strain cash flow. Holding adequate buffers reduces the risk of forced sale at an inopportune time.
When it may not make sense
Negative gearing may be inappropriate where:
- You are relying on tax refunds to meet mortgage repayments
- You have unstable employment or a variable income
- The property’s growth prospects are weak
- You are close to retirement and will lose the benefit of offsetting losses against high employment income
- You are already highly leveraged across multiple properties
For lower-income earners, the tax benefit is smaller and the relative cash flow burden larger. In such cases, a neutrally geared or positively geared property may provide more sustainable outcomes.
Strategic considerations
Sophisticated investors also consider:
- Debt structuring – Ensuring loans are structured correctly to preserve deductibility
- Ownership structures – Individuals, trusts, and companies have different tax outcomes (for example, companies do not access the 50% CGT discount)
- Timing of income and expenses – Legitimate prepayment strategies may affect the timing of deductions
- Interaction with land tax and state-based imposts
Professional advice is critical, particularly where multiple properties or entities are involved.
Conclusion
Negative gearing is not a tax loophole; it is simply the application of general deductibility principles within Australia’s income tax framework. It can be a powerful wealth-building tool when paired with strong capital growth, disciplined borrowing, and long-term holding.
However, it is not a strategy in isolation. It is a funding mechanism that relies on future growth to justify present cash losses. Investors should evaluate it through a total return lens, combining rental yield, capital growth, tax outcomes and risk tolerance – an approach consistently emphasised by advisers at H&R Block when assessing long-term property strategies.
In the right circumstances, negative gearing can accelerate portfolio growth and improve after-tax returns. In the wrong circumstances, it can magnify financial stress.
As always in property investing, the numbers, not the tax refund, should drive the decision.
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