How Does Negative Gearing Work?
Negative Gearing is when you borrow to acquire an investment and the interest and other costs you incur are more than the income you receive. These costs are then applied to reduce the tax that you pay on the rest of your income. In this way the Tax Office act to subsidise the holding costs of your investment property in conjunction with the rental income from your tenants.
Negative gearing of investment property in Australia is used as a means to make it easier to hold property and let it grow in value over time. The beauty of borrowing, or gearing, to invest is that it enables you to go into investments that might otherwise be closed to you.
The reason negative gearing can be attractive is that under current Australian Taxation law (as at 5 December 2001), an investor may be able to claim a deduction for the loss, which can be offset against other taxable income, such as salaries, business income or other investment income. Of course, if there is no growth in the value of the asset, you could lose money even after the tax benefit is taken into account.
Negative gearing may not be suitable for all investors. Although it can lower your tax obligations, the full implications will depend on your personal situation, and the type of investment you choose.
Key Advantages of Negative Gearing
- Enables you take on a higher level of investment than might otherwise be possible.
- In favourable market conditions, your earnings can be multiplied.
- Generally, if the cost of borrowing exceeds the income generated by the investment, this excess is an allowable deduction.
- Gearing can multiply your capital gains while reducing your tax.
Key Disadvantages of Negative Gearing
An asset may not provide the return you expect. Because the property market is constantly changing, the conditions under which you are borrowing may not remain the same. If you over-extend your borrowing, rising interest rates could restrict your ability to meet the loan payments. If you rely on the income the investment produces, there may be periods where it produces little or no income, or even losses. Gearing can multiply your loss. Should you wish to sell the asset and pay the loan off earlier than expected there may be repayment fees or penalties which apply to the loan.
Can you afford negative gearing?
You can afford it only if you have money left over from your other expenses, and only if you can go on expecting reliable income from your job or other sources.
Judge the investment first, not the tax benefit. A good investment must sooner or later show a profit, not a loss. A good investment should also give you a reliable and rising income. This will reduce your losses over time, and eventually you will expect to pay some tax. To choose a good investment takes time, knowledge and experience. Get independent, licensed advice if you do not want to research and manage investments yourself.