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There are pros and cons to both positive gearing and negative gearing an investment property. In this post we'll briefly outline what each approach entails, and the primary benefits and considerations of each.
Negative Gearing In Australia May Be A Changing Landscape
The consideration of whether to positively or negative gear is increasingly at the forefront of investors' minds at the time of writing given uncertainty around whether negative gearing will continue in its current form should there be a change in government. Importantly, the Australian Labor Party has made clear its stance on negative gearing, stating (as at January 14, 2019):
"Labor will limit negative gearing to new housing from a yet-to-be-determined date after the next election. All investments made before this date will not be affected by this change and will be fully grandfathered".
Views are mixed and there is much concern around the outcomes should Labor's proposed reforms be implemented. Propertyology provide a counter-view of the less than positive impact of proposed negative gearing changes.
For now, let's delve in to the differences in the two approaches to property investment, with an awareness that the landscape may be changing after the next Federal election.
What Is Positive Gearing?
As defined on ASIC's MoneySmart website, "positive gearing is where you borrow money to invest and the income from your investment is higher than your interest and other expenses. This means you will have extra money in your budget but you will have to pay tax on the additional net income".
The Benefits of Positive Gearing
The fundamental benefit of positively gearing a property is that you are provided an income stream. i.e. even after associated expenses, there is extra money earned from your property which can be used immediately as you wish.
When a mortgage is in place on the property, this extra cash can provide some breathing room to cope with any extra expenses or even potentially to cover an increase in repayments if there is an interest rate rise.
Additionally, if you are an investor focused on building a significant portfolio over time, there will be limits to the number of properties you can sustain and repay while negatively geared. If the expenses in holding the property are covered, there is virtually no limit to the number of positively geared properties you could accumulate.
The Downside of Positive Gearing
The less positive aspect of positive gearing is that the income you make from the property will be taxed at your marginal tax rate. This could result in you being taxed as much as 45% on what the property generates for you.
Additionally, properties which are able to be positively geared, especially for investors in their early stages of property investment, are likely to be in areas of higher rental yield and lower capital growth. In other words, while the property may generate an income stream, the time taken for equity to build in that property through capital growth may be significantly longer than in a negatively geared property (which typically offers lower rental yield and higher capital growth).
What Is Negative Gearing?
Again sourcing from ASIC's SmartMoney site, "Negative gearing is where you borrow money to invest and the income from the investment is less than the expenses. This is common for property investments, for example, where rental income is less than interest and other expenses. Essentially this means you are making a loss".
In summary, you must "top up" payments on your investment property from another source.
The Benefits of Negative Gearing
Negative gearing is a popular way to buy an investment property due to the tax breaks it provides investors. Currently, you are able to offset the loss you make on interest repayments against your income tax, while you can also deduct depreciation, capital works spending, property management and maintenance costs. Having these costs taken from your pre-tax income can offer significant savings.
Presuming that the value of your investment property increases over the long term, a negatively geared property will offer strong capital gains. Over time, rent will increase also. In this way, given time, a negatively geared property can eventually transition into a positively geared property.
The Downside of Negative Gearing
As mentioned earlier, negative gearing essentially means you are making a loss while holding the investment property, meaning that another source of income (usually a portion of salary) is required to cover costs in the short term.
Most importantly, if interest rates rise, the increased repayments required to hold onto the property could introduce significant financial stress, especially if there is no salary increase expected while these expenses increase.
As the flipside to positive gearing, there is also a limit on the number of properties in your portfolio you can negatively gear. A salary can only sustain so many expenses, and while it may be possible for some investors to negatively gear a number of investment properties, at some point there is no "extra" income (e.g. surplus salary) left to draw from to add further properties to your portfolio.
Negative Gearing vs Positive Gearing - Which Is Better?
As is usually the case with such questions, the answer is not black or white and depends on your individual circumstances, stage of the investment journey, and appetite for risk.
In general, unless you have a significant deposit to put towards an investment property, positive gearing is not likely to be a viable option in areas of high capital growth when in the early stages of investing. This is because high capital growth areas tend to have lower rental yields than slower-growth areas, meaning the income you receive from them will be less likely to cover your outgoings (particularly the mortgage repayment).
For more on rental yield, read "Is Rental Yield A Good Indicator Of Where To Buy Investment Property?".
If you are in a position to be able to negatively gear to purchase in an area of strong and stable capital growth, you will be purchasing a reliable long-term investment. Just remember that negative gearing will leave you more vulnerable to changes in the market such as increased interest rates, or minimal rent growth over long periods.
A helpful positive vs negative gearing comparison example is contained on ASIC's SmartMoney site and is worth reviewing when considering your own circumstances.
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We provide expert investment property management in Newcastle and Lake Macquarie. If you found this article helpful or enjoyable, please subscribe or share it with someone else who may benefit.
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