Gearing is a term used when you borrow money to invest in an asset such as an investment property. Negative, neutral and positive gearing describe whether you’re making a profit or loss, or if you are breaking even after you borrow money for its purchase.
When you borrow to invest in an asset…
…and the income you earn from that asset (e.g. rent) is less than your expenses.
As you’re making a loss you can deduct your expenses from your taxable income.
…and the income you earn from that asset (e.g. rent) is equal to your expenses.
As you’re breaking even you can’t deduct expenses from your taxable income.
…and the income you earn from that asset (e.g. rent) is more than your expenses.
This means you’re earning a net income from your property that will be liable for tax at your marginal rate. You can also choose to use that income to reduce the size of your loan.
Negative gearing is what happens when you borrow money to invest, and the income you make from that investment (e.g. rent from an investment property), is less than your expenses. Expenses can include maintenance, council rates, interest rates, insurances and property management costs. Negative gearing can make sense as a financial strategy when your property’s capital growth is likely to be greater than the loss you’ll make from any income/rental shortfall.
When can negative gearing be a sound investment strategy?
Negative gearing can be a good option when:
- You have enough income available to afford the property and make the repayments needed
- You’re confident that you can hold the property long enough for it to increase in value and achieve more capital gains than you’ll spend on the property
- You’re looking to reduce your tax liability.
The primary goal of negatively gearing a property is to see the value of the property rise to a point where a healthy profit (over and above all expenses) can be made when you sell.
When can negative gearing go wrong?
Negative gearing can become a problem when:
- Your cash flow isn’t enough to cover your expenses
- You have to sell your property, potentially giving up significant future growth in value as a result
- The market value of your property falls or grows more slowly than expected. In this case, you’re achieving limited capital gain and you’re covering out-of-pocket expenses associated with the property from a different income source. So, you’re spending money, but not getting any net financial gain from the property over the long term.
What's right for me?
Negative gearing can come with risks and is not right for everyone. Seeking financial advice is always a good idea before deciding on a gearing strategy that will work for you.
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