Quite often an investor or member of the media will mention the word negative gearing, but what does it mean exactly?
Gearing simply means borrowing money to buy an asset. And the reason you might hear so much about it is that the government’s gearing policies have an 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.
What is negative gearing?
Negative gearing is when you borrow money to invest into an asset (usually property) and the income you make from the investment i.e. the rent, is less than your expenses, meaning that you’re at a loss.
Australian law 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.
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 neutral gearing?
Neutral gearing is when you borrow money to invest in an asset and the income you make from that investment, i.e. the rent, is equal to your expenses.
This means that you are breaking even on your investment and cannot deduct any losses from your taxable income.
What is positive gearing?
Positive gearing is when you borrow money to invest in 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.
What you need for negative gearing to work
By allowing prospective investors to deduct any losses they make on their investment property from their taxable income, negative gearing makes it possible for a much larger proportion of the population to buy an investment property, much sooner than they would be able to if they had to rely solely on positive gearing. And this can help to reduce rental prices, by increasing the amount of rental housing available on the market.
Before deciding on which gearing strategy works best for you, we’d recommend speaking to a financial advisor, so that you better comprehend the potential drawbacks and rewards.