How does negative gearing work
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Rarely a day goes by without an investor or member of the media mentioning negative gearing. But what does it mean exactly?
Gearing simply means borrowing money to buy an asset. And the reason you hear so much about it is because the government’s gearing policies have a big impact on how attractive the property market looks to investors, which, in turn, has a big impact on everything from the amount of housing available to the average weekly rent.
Here’s what you need to know about the three types of gearing: negative, neutral and positive.
What is negative gearing?
Negative gearing is when you borrow money to invest into an asset (usually a property) and the income you make from that investment, i.e. the rent, is less than your expenses, meaning that you’re making a loss.
People, of course, invest in properties to make money, and so making a loss is never ideal. But Australian law also allows investors to deduct any losses they make on an investment property from their taxable income, which makes it far easier for people to invest in the property market. This is the principal benefit of negative gearing – and one that often leads to an increase in rental housing supply.
A lot of investors who buy properties to rent out to tenants don’t 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.
Australian law also allows investors to deduct any losses they make on an investment property from their taxable income.
And so, the aim of the game for many 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.
What is positive gearing?
Positive gearing is when you borrow money to invest into an asset and the income you make from that investment, i.e. the rent, is more than your expenses.
This means that you are earning a consistent income from your investment property, and will also make a capital gain from the sale of the property if house values increase during your ownership.
Of course, as you’re earning income from your property, you won’t be able to make any deductions from your taxable income and the income from your investment property will be subject to income tax at your marginal tax rate.
However, you could use your surplus income to reduce the size of your loan.
Ultimately, positive gearing is the best option for investors, but high competition among landlords means that it’s not always possible to increase rents to a level that allows them to earn a constant income on their investment.