There can be positive gearing (where the rental income provides a profit above than the cost of the mortgage) or negative gearing (where the rental income is less than the cost of the mortgage).
What is negative gearing?
Negative gearing is when the cost of the home loan for the investment is greater than the rental income received from the property.
As well as the tax concessions on offer for negative gearing, you can still make a long-term profit on your investment once the value of the property increases (if it increases at all) – but you have to pay capital gains tax on that profit.
Watch the video below for a visual case study of what negative gearing is all about and how it might work in practice.
Source: InvestSMART Group
What is positive gearing?
Positive gearing is a much more straightforward concept that its negative counterpart. Positive gearing is simply when the cost of holding your investment through interest is less than the income you receive from it. This is the ideal scenario for most property investors, as you are immediately making a profit on that investment.
Positive gearing isn’t always possible right away, however, which is why so many people turn to negative gearing.
How does negative gearing work?
Essentially, the basic goal of a negatively geared property is to turn a loss into a gain. You obviously shouldn’t invest in a property with the intention of making a loss, but if your property is not earning enough in rent to pay for itself, then at least you can write that loss off when tax time comes around.
There are many different reasons why the cost of a property can outweigh the income, but they can be divided into two different categories:
- Non-cash costs such as the depreciation in the property’s value
- Cash costs such as interest payments, bank fees, insurance premiums, property management fees, and more
If you add the amount of cash and non-cash costs together and they are more than your rental income from the property, then there is a net rental loss. You would then claim this loss as a tax deduction against your taxable income, such as your salary.
However, Labour is proposing to remove the ability of landlords to offset their losses against other income, so if there is a loss on one property, there is no way of recovering that money through tax deductions.
This proposal has been met with mixed response. The New Zealand Taxpayers’ Union, for example, says it would lead to landlords increasing their rent prices.
What investment property expenses can be claimed as tax deductions?
If you own an investment property, then are several other expenses that you can write off as tax deductible. These expenses are related to the maintenance of the property:
- Advertising for tenants, agent’s fees and commission.
- Interest payments and loan fees.
- Council rates, land tax and strata fees.
- Depreciation of items such as stoves, fridges and furniture.
- Repairs, maintenance, pest control and gardening.
- Building and landlords insurance.
- Stationery, phone costs and any travel to inspect the property.
To successfully make these tax deductions, you are required to keep official documentation of such expenses, including bank statements and receipts. You will also need an accurate depreciation schedule and capital works schedule.
Pros and cons of negative gearing
As with any investment strategy, there are potential drawbacks as well as potential benefits to negative gearing. Many people lose money on negative gearing because they aren’t fully aware of the consequences.
Canstar has compiled a brief list of the pros and cons of negative gearing to give you some idea of how to work out for yourself whether it might be a good idea for your situation.
Reduce your taxable income:
Property investors can usually turn their investment losses into a positive by offsetting it against their taxable income, meaning they pay less in tax for that financial year. If you’re disciplined with your investments, then negative gearing is one way to absorb any interest losses over the short-term.
This enables low income earners and middle income earners to invest in property, which they likely would not be able to afford otherwise.
Besides tax savings, arguably the biggest benefit of negative gearing is that it can allow an investor to afford to buy a property with the potential for high capital growth. Capital growth potential is the most common goal of property investors.
Properties that have positive cashflow immediately are hard to find, but even if there’s no immediate return, negative gearing allows you to more easily afford some properties that will increase in value in the future.
More property choice options:
By negatively gearing, investors can give themselves many more property options to choose from. Negative gearing can open up the range of properties someone can afford to invest in to include properties where the rent would not necessarily fully cover the mortgage to on it.
This can potentially allow an investor to potentially invest in safe, secure areas that are likely to provide regular rent, which is always a sound investment strategy, or in high capital growth areas.
As with any investment strategy, there is a degree of risk that comes with negative gearing. Borrowing money to fund a property comes with the possibility of rising interest rates and depreciation in the value of your property, which can eat away at the potential capital gains.
Many people incorrectly assume that negative gearing is a fool-proof strategy to “save money” on tax, which is very dangerous. No investment strategy can be called “fool-proof” or “safe”, and significant losses are possible if the investor underestimates the amount of the loss they are making on their investment.
Dangerous for housing affordability in the property market:
Many people now simply see property as an investment, which is one of the causes of the skyrocketing house prices across the country. It drives up house prices while not doing much to generate supply.
Increasing house prices is not terrific for the economy as a whole because it means people are borrowing more and more money. It’s a trend that could well have negative long-term consequences.
More people borrowing more money:
While it’s actually the middle and lower income earners who are using negative gearing, negative gearing does lend itself to high income earners. Such people can afford to buy properties that don’t pay for themselves, on top of financing their usual lifestyle.
Negative gearing may encourage those with limited income to invest solely in one property because it’s all they can afford, rather than investing in a more diversified portfolio.
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