Negative Gearing 101

Generally, people invest to get a positive result. So why do they adopt a negative gearing strategy? A negative gearing strategy trades off tax deductible rental losses during the ownership period against a projected capital gain on the sale of the investment property where only 50% of the capital gain is taxable. 

 

Critically, the investor is receiving all the growth on the portion financed by the lender, and isthus leveraging the investment with a small deposit.

 

‘Gearing’ is a term used in engineering. In car technology, when you have a manually operated car there is a gear shift,which has several settings.  

 

Level one is usually used to get the car to move from stationary position, generally very slowly. Once it starts to move,shifting into second gear moves the car with some power but still relatively slowly. As the car moves with more power,the driver is more easily able to pick up speed by shifting to higher gears as the car can now move quite fast. 

 

Similarly,the use of pulleys allows people to lift heavily weighted items almost by themselves.

 

In property investment terms, borrowing money to finance the purchase of a rental investment is similar to shifting the gear in a car to get it to  move faster, or using the pulley to lift that heavy load singularly. A small deposit is ‘geared’ up with a loan to enable the investor to acquire a rental property investment thatwould otherwise not have been possible. 

 

Gearing into an investment property can be ‘positive’ or ‘negative’, depending on whether the interest expense will result in a net rental profit or net loss after all expenses are covered.

 

A ‘positive gearing’result producing a net rental surplus/profit instead of a loss will be achieved if, for example,the net rental expenses areonly 1% ($5,000) and the interest rate hasfallen to 5% ($20,000). After taking depreciationinto account, additional cash from the tax savings will have been generated.

 

For tax benefits to contribute positively, the investor has to be on a high marginal tax rate. He also has to have enough cash to cover the cash rental loss each year of ownership. 

 

Risk areas associated with negative gearing strategies include interest rate fluctuations andnet capital growth not exceeding rental losses.

 

As the tax-free threshold has moved to $18,200, negative gearing strategies will not suit those with a taxable income below this amount. The benefits are low for those on the 19% (+1.5% Medicare) rate with taxable incomes between $18,200 and $37,000.

 

In my experience,I have found that negative gearing strategies have worked well for investors who purchased well-positioned properties and held on to them for a long time,riding at least one property cycle,if not more. Very high inflation increased the value of the properties, while the value of the  loans fell as increased income made serviceability easier. Other investors who benefited werethose who bought well in the first place.

 

Investors who suffered were those who used negative gearing strategies to acquire properties that did not grow in value. In the process they used their earnings to cover annual rental losses. 

 

Others who fared worse were those who purchased with rentals guaranteed for a few years by the developer. Soon after this period expired, the property value was below not only the purchase price but, worse,the outstanding loan. Selling the property meant the proceeds were not sufficient to repay the loan. 

 

In slow growth periods, investors can manufacture capital gain with renovations or improvements thatcan immediately improve rental yields. Given the high demand and short supply of rental accommodation, a very popular strategy at the moment is to erect a granny flat at a property ona larger block. How much of a capital gain this strategy can produce is still to be seen. 

 

Because of the positive net rental income it generates,the granny flat strategy is being adopted by those who do not have excess cash from their salary to support a negative gearing strategy but have limited deposits to start investing. These properties are generally further away from the CBD so they are cheaper to buy. Investors are therefore buying more of them, generating an income stream even though they are not accruing capital gain – at least in the short term.

 

It is generally accepted in the industry that negatively geared properties are better properties and better located, with expectations of higher capital gain compared topositively geared properties that are cheaper to buy but situated in low capital growth areas. 

 

Because it costs little to hold, positively geared strategies are adopted by people who want to receive a positive income stream to live on or to use to pay for rental losses of negatively geared properties in their portfolio.