Negative Gearing Explained: How Does It Work For Investment Properties?

Negative gearing is a strategy used by investors in the real estate market to reduce the amount of tax they pay on their primary income. It involves borrowing money to purchase an investment property, with the costs of owning the property (such as mortgage interest) exceeding the rental income generated. The resulting loss can then be offset against other income, such as wages or salary, to provide tax savings. 

In this article, we’ll dive deep into the concept of negative gearing. We’ll explain how it works, outline its benefits and risks, and provide examples to help you understand what it means for investment properties. 

How does negative gearing work?

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So, what is negative gearing? 

Negative gearing occurs when the expenses of owning a rental property exceed its income. This creates a taxable loss, which can be used to offset other sources of income for tax purposes. Here’s how the negative gearing process works for investors. 

1. Purchasing an investment property

To engage in negative gearing, an investor borrows money to purchase an investment property, typically through a mortgage. The borrowed funds cover a significant portion of the property, if not the entire purchase price.

2. Generating rental income

The investor rents out the property to tenants, generating rental income. However, in many cases, the rental income needs to be increased to cover all the expenses associated with the property. These expenses include mortgage repayments, property management fees, maintenance, and insurance premiums.

3. Tax deductible expenses

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The investor can deduct the expenses associated with the investment property from their taxable income. These expenses may include mortgage interest payments, council rates, property management fees, repairs and maintenance costs. The total deductible expenses contribute to the overall loss associated with the property.

4. Tax savings 

The loss incurred from the investment property can be offset against the investor’s other income, such as wages or salary. This reduces the investor’s taxable income and their overall tax liability. The investor can claim these tax benefits when submitting their annual tax return.

5. Long-term capital growth

While negative gearing may result in short-term losses, the investor may benefit from long-term capital growth. Over time, the value of the investment property may increase, resulting in capital gains when the property is eventually sold. These capital gains can offset the previous losses incurred through negative gearing.

The benefits of negative gearing

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Negative gearing can have several potential benefits for investors. These include:

• Tax savings — One of the primary advantages of negative gearing is the potential for tax savings. By offsetting the losses from the investment property against other income, investors can reduce their taxable income and lower their overall tax liability. This can provide valuable cash flow benefits, particularly for high-income earners.
• Cash flow management — Negative gearing allows investors to manage their cash flow by using the rental income from the property to cover a portion of the expenses. While there may be a shortfall between the rental income and expenses, investors can use their own funds to cover this gap, taking advantage of potential tax benefits in the process.
• Property portfolio growth — Investors who engage in negative gearing may benefit from long-term capital growth. As property values increase over time, the investor’s equity in the property grows, potentially leading to significant gains when the property is sold. This can contribute to the growth of a diversified property portfolio.
• Wealth creation — Negative gearing can be seen as a wealth creation strategy. While the investor may experience short-term losses, the potential for long-term capital gains and the accumulation of property assets can provide a pathway to building wealth over time. This can be particularly advantageous in a growing property market.

Risks associated with negative gearing

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While some investors explore negative gearing for tax benefits, some risks are also associated with it. It is important for investors to carefully consider these risks before engaging in negative gearing.

• Cash flow challenges — Negative gearing relies on the investor’s ability to cover the shortfall between rental income and expenses. If the investor experiences unexpected financial difficulties, such as job loss or increased interest rates, they may struggle to meet the ongoing financial obligations associated with the investment property.
• Market volatility — Property markets can be volatile, and the value of the investment property may not always increase as anticipated. If property values decline or remain stagnant, the investor may not realise the expected capital gains needed to offset the previous losses incurred through negative gearing. This can impact the overall financial viability of the investment strategy.
• Interest rate risks — Negative gearing is closely tied to borrowing money to finance the investment property. If interest rates rise significantly, the investor’s mortgage repayments may increase, further amplifying the gap between rental income and expenses. This can strain the investor’s cash flow and financial stability.
• Dependency on tax benefits — Negative gearing heavily relies on the availability of tax benefits. Changes to tax laws or policies could impact the deductibility of expenses associated with investment properties. It is crucial for investors to stay informed about any potential changes that may affect the viability of their negative gearing strategy.

Example of negative gearing

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Let’s consider a hypothetical example to illustrate how negative gearing works:

Dave decides to invest in a rental property. He purchases an apartment for $400,000 using a mortgage and rents it out for $400 per week, resulting in an annual rental income of $20,800. However, Dave’s expenses associated with the property, including mortgage interest, property management fees, and maintenance costs, amount to $25,000 per year.

As a result, Dave experiences a $4,200 loss each year from the property ($25,000 – $20,800). To reduce his taxable income, he can offset this loss against his other income, such as his salary. Assuming Dave is in the 30% tax bracket, he can potentially save $1,260 in tax ($4,200 x 30%).

While negative gearing results in short-term losses for Dave, he may benefit from long-term capital growth if the property’s value increases over time. This capital growth could offset the previous losses incurred through negative gearing, resulting in a net gain when the property is sold.

We’re the experts Newcastle locals trust when it comes to negative gearing a property

While negative gearing offers potential tax savings and the opportunity for long-term capital growth, it is not without risks. Investors must carefully consider their cash flow, market volatility, interest rate risks, and potential changes in tax laws before engaging in negative gearing. 

At Watson Mortgages, our mortgage brokers can walk you through the potential benefits and risks of negative gearing for your investment property. Contact us online or call us at (02) 4018 7505 and discuss your options today. 

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