If you’ve spent any time at all researching property and investment, you’ve probably come across the term ‘negative gearing’. It’s everywhere right now. And at first glance, it doesn’t seem to make much sense.
After all, it’s an investment strategy that involves losing money, right? How can that make sense? Well, negative gearing is an extremely popular investment strategy, especially here in Australia. So while it may appear crazy, there’s actually strong logic behind it.
Ultimately, it’s about tax. Investors use negative gearing as a way to reduce their taxable income and ultimately increase their wealth over time.
But that probably doesn’t answer all your questions about negative gearing. So, let’s take a closer look. Today, we’re going to explore what negative gearing is, how it works, and what kind of an impact it can have on investors, the economy, and tax returns.
Let’s get started!
What is Negative Gearing in Simple Terms?
Let’s say you buy a property with the intention of renting it out to tenants. Great. You could end up – as many do – actually paying more in mortgage interest, maintenance, and other expenses than you receive in rent each month. If this happens, you’ll end up with a ‘negative cash flow’ – i.e., you’re losing money.
Some investors do this deliberately. Woah there! Hang on – people deliberately lose money on property!? That’s right. Some investors understand that they’re losing money on their property investments (at least in the short term). But here’s the catch: this can help them offset losses against their taxable income, potentially reducing their overall tax bill.
Starting to make sense? Well, it does to many Australians. According to one study, as much as 6.1% of taxpayers (over 935,000 people) in Australia actually use negative gearing to save money.
How Does Negative Gearing Work?
It’s actually pretty simple. Negative gearing works by allowing investors to deduct their investment property’s expenses from their taxable income. These expenses can include the interest paid on loans, property management fees, insurance, repairs, and depreciation. By reducing taxable income, the investor may pay less tax in the short term.
Let’s clear things up with an example. Let’s imagine you own a property that costs $30,000 a year to hold (including extra costs like loan repayment and maintenance). However, you’re only generating $20,000 in rental income. There’s a $10,000 shortfall. This $10,000 can be deducted from your other income (like salary), lowering the amount of tax you need to pay.
That’s basically all there is to it. Although this is a controversial strategy in Australia, we should make it clear that negative gearing is not illegal.
Negative Gearing vs. Positive Gearing
If negative gearing exists, does that mean there’s such a thing as ‘positive gearing’? Absolutely. And the key differences come down to cash flow from the investment. Let’s take a look:
- Negative Gearing: The costs of owning the investment exceed the income generated by it. So investors rely on potential capital gains (an increase in the property’s value) to make a profit in the long run. What makes this appealing in the short term> The tax benefits.
- Positive Gearing: Let’s switch it around. Positive gearing occurs when the income generated from the investment (like rent) exceeds the costs of owning it. That means a positive cash flow. Okay, there’s no immediate tax relief, but the investor is making money each month and may still benefit from capital gains.
Is Negative Gearing a Good Thing?
We mentioned earlier that negative gearing is controversial. There’s no doubt about it. To some, it feels like ‘cheating,’ while to others it’s simply a smart investment choice. Your perspective will largely boil down to your investment goals and financial situation.
- For Investors: Just because investors can save tax dollars by negative gearing doesn’t mean it’s a smart move for everyone. If the investor has a higher taxable income – and enough to invest – negative gearing can have tax deduction benefits. For many, that means more free capital to invest further. Don’t forget, you could also benefit from capital gains. As property markets grow, you could be in for a large payout further down the line. However, that involves significant risk.
- For the Economy: There’s no clear-cut answer here. Economists are divided on whether or not negative gearing is a plus for the economy. Some argue that it stimulates investment in the property market, boosts construction, and provides rental housing. Others posit that negative gearing contributes to inflated property prices and makes homeownership less affordable for first-time buyers.
What Can You Claim With Negative Gearing?
It’s clear why some investors use negative gearing. We’ve mentioned that it can help to reduce tax bills in the short term while securing capital gains in the long run. But what exactly can investors claim with negative gearing? Let’s take a look at some examples:
- Mortgage Interest: The interest paid on loans for purchasing the investment property is typically deductible.
- Property Management Fees: Fees paid to property managers for tenant sourcing, rent collection, and other services.
- Repairs and Maintenance: Costs for maintaining the property, including repairs, renovations, and replacements of fixtures.
- Insurance: Property insurance, as well as landlord insurance, can be claimed.
- Depreciation: Depreciation on the property’s structure and its contents (such as appliances) can be claimed as a tax deduction.
- Council Rates and Utilities: Property taxes, water rates, and other utility costs associated with the property can be deducted.
Let’s make a few things clear, though. Whether or not property investors can actually claim any or all of these deductions depends on a variety of factors and is by no means guaranteed.
Who Does Negative Gearing Benefit?
According to the research cited earlier, almost a million people benefit from negative gearing in Australia. Plus, supporters argue that it helps the housing market. But does that mean it’s good for everyone?
- Wealthier Investors: Of course, those with higher incomes and spare capital can benefit the most from negative gearing through tax deductions. Especially if they can afford ongoing losses for an extended period of time.
- Property Investors: People investing in property specifically benefit from negative gearing, particularly in markets with rising property values. But it works best when property value increases over time (as it currently is).
- The Government: The government offers the tax incentives that make negative gearing possible. However, it could be argued that this leads to reduced tax revenue. For many, this sparks debates about tax fairness and the system’s long-term sustainability.
Finals Thoughts on Negative Gearing
So, it’s clear what negative gearing is: it’s an investment strategy that helps property owners pay less in taxes in the short term. By allowing investors to offset the costs of owning a property against their taxable income, negative gearing can reduce tax bills while offering the potential for long-term capital gains. However, it’s not without risk.
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