Most people immediately think of negative Gearing when the subject of Investment Properties is mentioned. Somehow popular opinion is that Negative Gearing is the main reason for investing in property. Let’s look at what negative gearing is and what it actually does for an investor Plus we will also consider the other option; Positive Gearing.
Meaning of Negative Gearing
Negative gearing occurs when the cost of owning a rental property outweighs the income it generates each year. This creates a taxable loss, which can normally be offset against other income including your wage or salary, to provide tax savings. Borrowing to buy a property is known as Gearing and if the asset being purchased doesn’t produce enough income to cover the expenses then it has a negative yield or return, hence the term Negative Gearing.
The running costs of the property include loan interest payable, loan fees, Council rates, Body Corporate fees, Accountants fees, Property Management expenses to name a few. Income refers to the amount of rent received. Obviously if the expenses are more than the rent there is a shortfall. Usually this means you have to put money towards the cash flow of the property.
Benefits of Negative Gearing
Negative gearing can provide Taxation benefits to you. How much you can claim will depend on a myriad of factors such as income level, loan size, interest rate, rental income. The negative gearing benefit could be the difference between owning a property or not.
Some people think that they should buy a property so they can get tax benefits and reduce the tax they pay. While this may be possible depending on your circumstances, the fact is that eventually the property will turn into a positive geared property as the rent goes up and the debt decreases.
At that point, you then end up with the same problem all over again. The property produces more income and therefore you are paying more tax. Selling the property for a profit can incur Capital Gains Tax, defeating the reason for purchasing in the first place.
Negative Gearing is detrimental to borrowing capacity because it creates a commitment.
Property is primarily a wealth building tool that happens to have tax benefits as an investment and should only be considered in that way. We recommend you speak with one of our Financial Planners
Meaning of Positive Gearing
Positive Gearing is the opposite of Negative Gearing, obviously. In this situation, the incoming rent exceeds the running expenses of the property so that a surplus income is generated for the owner. There can still be a loan on it, hence the Gearing part, but the rent covers the interest costs and running expenses of the property. Accordingly there is no taxation benefit; rather there is a taxation obligation for any surplus income. So we can see that Positive Gearing results in a Positive cash flow property.
The good news is that this income can be used to assist with the shortfall of any other properties that exist within the portfolio. For example, if there are two properties and one has a shortfall of $50 per week after all expenses and the other has a surplus of $50 per week after all expenses then there is no need to contribute your own income to support the two properties.
Positive Gearing is an advantage for borrowing purposes because it increases income.
Clearly a change in interest rates can increase or decrease your property expenses depending on where the rates go. Add several increases over a year and your existing contribution to the property increases considerably. You should understand that there is no corresponding increase to rent at this point so any extra expense comes from your own money. Of course, reductions in interest rate will reduce the expenses and impact the taxation position if negative Gearing is involved. Less interest cost means less negative gearing available. On the other hand if the interest rates decrease and the property is Positive Geared then you will have more surplus available.
How to find positive cash flow properties
All properties are cash flow positive unless you have to borrow money in which case the amount you need to borrow, or gear, becomes the deciding factor. The variables to this rule relate to loan size and level of expenses. For example, the body corporate costs on an inner city apartment complex can run into several thousand dollars while a standalone house will not have that added cost. . Generally speaking, properties that produce enough rent to cover running costs from day one will usually be located in areas that have reduced capital growth. Properties that have high capital growth will have lower rental returns.
Naturally, a loan will add to the properties total expenses. You should bear in mind that the rent is only able to cover a certain dollar amount worth of expenses before your income is required to make up the difference.
It’s worth speaking to one of our Property Advisors to discuss your situation and decide on which gearing method suits you.