Negative gearing: How does it work

Gearing simply means borrowing money to buy an asset. In the property industry, it usually refers to your home loan.

A property is negatively geared when the interest you are paying on the loan is more than the income you earn from the rent. As a result, you are making a loss.

A property is neutrally geared when the interest you are paying on the loan is equal to the income you earn from the rent. As a result, you are breaking even.

A property is positively geared when the interest you are paying on the loan is less than the income you earn from the rent. As a result, you are making a profit.


What is negative gearing?
Negative gearing is a term used to describe a financial practice whereby you reduce your tax bill by offsetting the loss you make on a negatively geared property against your taxable income. 


The positives of negative gearing
If negative gearing means you’re making a loss, how can it be positive?

To be sure, people invest in properties to make money. But most investors who rent out properties don’t actually expect to make money on the rent.

Instead, they buy properties with the intention of cashing in on a property’s long-term capital growth. Which is to say, they buy a property in the hope that its value will eventually increase to a point whereby a healthy profit can be made from its sale.

And so, the aim of the game for investors is to limit their losses until the time comes for them to sell – and negative gearing is a good way to do that.

Essentially, negative gearing works if the money an investor makes from a property’s capital growth is greater than the loss they make from the rental shortfall.

Below, we’ve provided an imaginary case study to help you form a clearer picture of the benefits of negative gearing. To keep things simple, we’ve only factored in rent and interest payments. In reality, there are many more types of expenses related to owning property.

Capital growth from negative gearing
An investor buys a property for $440,000 and takes out a $400,000 loan at an interest rate of 7%. The annual interest payable on the loan is $28,000.

The investor charges $430 per week in rent, which adds up to an annual rental income of $22,360.

Based on the figures above, the investor is paying $28,000 in interest but only earning $22,360 in rent, which means they have a rental a shortfall of $5,640 per year.

This means that they are making a loss and their property is ‘negatively geared’. The investor can offset this amount against their taxable income, which means their taxable income would be reduced by $5,640. As a result, they would pay less tax.

A year later, the property’s value goes up by 10%. The property is now worth $484,000.

And so, at the end of one year, the investor has paid out $5,640 in interest, but seen their property’s value increase by $44,000. Which is to say that, even though the investor paid more on interest than they received in rent, they are $38,360 richer than they were 12 months ago, as the total value of their assets has increased.

In short, negative gearing will make you money if the property’s long-term capital growth is greater than the loss you make in rental shortfall.

 

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This article provides general information only and has been prepared without taking into account your objectives, financial situation or needs. We recommend that you consider whether it is appropriate for your circumstances and your full financial situation will need to be reviewed prior to acceptance of any offer or product. It does not constitute legal, tax or financial advice and you should always seek professional advice in relation to your individual circumstances. All loans are subject to lenders terms and conditions – fees, charges and eligibility criteria apply.