When it comes to investing in property, you might have come across the term ‘negative gearing’, but do you fully understand what negative gearing actually is?
Negative gearing is where your rental income from your rental tenants is not enough to cover your mortgage repayments and other associated property costs, like property management fees so you end up making a loss. In order to make up the difference, you have to pay the remainder out of your own pocket every week or every month.
The majority of properties within the Australian property market are negative geared, so the likelihood of you purchasing one is high, especially as they are much easier to find compared to a positive geared property. So, if you are making a loss every month, then why are so many investors using this investment strategy and what is the appeal?
At the end of the day you are investing in property to make money, not lose money. However, even though a negative geared property generates a loss it can produce positive cash flow due to tax.
Let’s say you receive a rental income of $500 per week, which is $26,000 per annum. However, you are paying $30,000 in interest repayments per annum. This leaves you with a shortfall of $4,000, which is approximately $333 per month that you need to fork out of your pocket. However, as an investor you are able to claim a variety of expenses back in tax.
Expenses that you can claim in tax include:
Borrowing and interest expenses
Council rates and water charges
Property agent fees and commissions
Body corporate fees and charges
Advertising for tenants
Repairs and maintenance
Stationery and postage
Gardening and lawn mowing
It is important to remember though that you can only claim expenses on your rental property when it is rented or available for rent. You cannot claim tax when you are renting the property, as this is classed as your primary place of residence or when it is untenanted.
If you are entitled to a large refund at the end of the year, then you don’t need to wait until the end of the tax year to claim this tax back. You can lodge a PAYG withholding variation application which allows the ATO to adjust the amount of tax withheld from your income. This means that you will be in pocket every month and can use this money straight away rather than waiting for a lump sum at the end of the year.
As well as your negative geared property having positive cash flow through numerous tax deductions, you should also consider capital growth. A property should be viewed as a longer term investment, and as properties tend to go up in value every seven to ten years you can benefit from capital growth. In markets where there has been rapid growth, such as Sydney’s property market these last few years, your property could go up in value by a staggering $100,000 in just one year.
So, now we know what negative gearing is, what are the advantages and disadvantages of this investment strategy?
Many investors like to invest in negative geared properties due to the great benefits this type of property offers.
1) Tax savings
As mentioned above, one of the main advantages of negative gearing is the numerous tax savings you are entitled to as a property investor. Who doesn’t want to save tax? As your property is generating a loss, you are able to offset your loss against your income allowing you to reduce your taxable income; thereby saving tax. This is particularly good for high income earners as their taxable income and tax bracket is so much higher.
2) Easier to find
As the majority of properties are negative geared, they are far easier to find especially within the inner city areas and a radius of 10km from the CBD.
3) Capital Growth
A negative geared property tends to grow at a higher and faster rate compared to a positive geared property due to its location. If bought in the right place at the right time, then you could benefit from high capital returns which can be re-invested into your next property.
4) Affordable for tenants
As rents are lower and more affordable, this often means that you might be able to secure a tenant for the long term reducing the risk of having to find new tenants to occupy the property.
As well as there being various advantages to negative gearing, investors should also be wary of the disadvantages that a negative geared property involves.
1) Higher element of risk
As a negative geared property is ultimately costing you money to hold, if circumstances were to change such as interest rates increase or you unexpectedly lose your job, then you might struggle to afford to pay the loan repayments. If things got really bad, then you might have to sell the property, which again is not a quick process as it takes time to sell a property and you might end up losing money overall by selling at a lower price.
2) Surplus cash required
It is essential that you have surplus cash left over from your ordinary income after expenses which you can utilise to make up the shortfall. This also means that budgeting is required. By not having any surplus cash, you won’t be able to afford to pay the shortfall difference.
3) Negative cash flow
There is a chance when holding a negative geared property, that after tax it generates a negative cash flow, or in other words a loss. It is therefore important that you buy in the right area and do your sums first to ensure that even after tax you are making a profit, or at least experience capital growth.
4) Risk of vacancy
Like any property investment, there is always the risk of vacancy and not being able to find rental tenants for your property. The longer the property remains untenanted, the more it will end up costing you so it is important to firstly buy in a location that has high demand, but low supply, and if using a property manager, then ensure that they are doing everything they can to find you a tenant.
5) Reduced borrowing capacity
If you are making a loss, then if you require future loans, then a lender might be more reluctant to increase your borrowing capacity as you are not generating an income from your property.
6) Long term strategy
To reap in the rewards, you need to think of this property as a longer term strategy. The longer you hold on to the property, the greater the chance your property will grow and double in value, particularly if you hold it for ten years over a full property cycle. It will not work in your favour if you only hold this property for a year or so.
As most properties are negative geared, it is relatively easy to find a negative geared property. You should look for high growth suburbs within a 10km radius of the CBD for high capital growth potential.
You also need to do your sums as what might be a negative geared property for one person, might not be negative geared for you, due to different factors such as loans and rate of interest repayments.
It is important to note that purchasing a negative geared property is not for everyone, especially if you have limited funds to pay the shortfall every month. It can also be a riskier option, especially if you don’t have a plan to minimise your risk. You should therefore consider negative gearing if you have money left over every month from your salary and you are in a stable job as well as on a high income and tax bracket.
You need to take your end goals into account as well and know what you are trying to achieve from owning a negative geared property. If your goal is to reduce your taxable income whilst creating wealth by owning more properties then buying a negative geared property could be for you. However, if you want a lower risk strategy that brings in cash straight away then you might want to consider a positive geared property, but remember that you should do your sums first as a negative geared property can produce positive cash flow after tax and it generally brings in higher capital growth over the long term.
Before making a decision to buy a property, ensure you speak to a Mortgage Broker or financial adviser to check your borrowing capacity and to check this negative gearing strategy is right for you.