How neg­a­tive gear­ing works

Central Queensland News - - REAL ESTATE | INDEX -

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. In the prop­erty in­dus­try, it usu­ally refers to your home loan.

* A prop­erty is neg­a­tively geared when the in­ter­est you are pay­ing on the loan is more than the in­come you earn from the rent. As a re­sult, you are mak­ing a loss.

* A prop­erty is neu­trally geared when the in­ter­est you are pay­ing on the loan is equal to the in­come you earn from the rent. As a re­sult, you are break­ing even.

* A prop­erty is pos­i­tively geared when the in­ter­est you are pay­ing on the loan is less than the in­come you earn from the rent. As a re­sult, you are mak­ing a profit.

What is neg­a­tive gear­ing?

Neg­a­tive gear­ing is a term used to de­scribe a fi­nan­cial prac­tice whereby you re­duce your tax bill by off­set­ting the loss you make on a neg­a­tively geared prop­erty against your tax­able in­come.

The pos­i­tives of neg­a­tive gear­ing

If neg­a­tive gear­ing means you’re mak­ing a loss, how can it be pos­i­tive?

To be sure, peo­ple in­vest in prop­er­ties to make money. But most in­vestors who rent out prop­er­ties don’t ac­tu­ally 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.

And so, the aim of the game for 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.

Be­low, we’ve pro­vided an imag­i­nary case study to help you form a clearer pic­ture of the ben­e­fits of neg­a­tive gear­ing. To keep things sim­ple, we’ve only fac­tored in rent and in­ter­est payments. In re­al­ity, there are many more types of ex­penses re­lated to own­ing prop­erty.

Cap­i­tal growth from neg­a­tive gear­ing

An in­vestor buys a prop­erty for $440,000 and takes out a $400,000 loan at an in­ter­est rate of 7%. The an­nual in­ter­est payable on the loan is $28,000.

The in­vestor charges $430 per week in rent, which adds up to an an­nual rental in­come of $22,360.

Based on the fig­ures above, the in­vestor is pay­ing $28,000 in in­ter­est but only earn­ing $22,360 in rent, which means they have a rental a short­fall of $5,640 per year.

This means that they are mak­ing a loss and their prop­erty is ‘neg­a­tively geared’. The in­vestor can off­set this amount against their tax­able in­come, which means their tax­able in­come would be re­duced by $5,640. As a re­sult, they would pay less tax.

A year later, the prop­erty’s value goes up by 10%. The prop­erty is now worth $484,000.

And so, at the end of one year, the in­vestor has paid out $5,640 in in­ter­est, but seen their prop­erty’s value in­crease by $44,000. Which is to say that, even though the in­vestor paid more on in­ter­est than they re­ceived in rent, they are $38,360 richer than they were 12 months ago, as the to­tal value of their as­sets has in­creased.

In short, neg­a­tive gear­ing will make you money if the prop­erty’s long-term cap­i­tal growth is greater than the loss you make in rental short­fall.

In an ideal world, you’d buy a neu­trally or even pos­i­tively geared prop­erty, but find­ing one is eas­ier said than done.

Peter Kouli­zos

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