‘So what’s negative and positive gearing and what are the pros and cons?’ This is a question I frequently get asked by my clients.
Currently a bit of a buzz word in investing! In simple terms, negative gearing is where you buy an investment property and the ongoing costs – mortgage interest, insurances and management fees all outweigh the rental income you receive.
Say you buy an investment property for $650,000 and you borrow $585,000 (90% loan) from the bank. Your repayments would be $29,250 @ 5% per annum. In return, your rental income is $26,000 ($500 per week), giving you a shortfall of $3,250 per annum plus lender’s mortgage insurance, other insurances and management fees which could take you to around $6,000 per annum out of pocket.
Disadvantages of this investment structure – with the example above, you would be out of pocket annually so not a good investment so far. In addition, you need to account for maintenance of the property along with the property being unoccupied for a short time period. All these costs could be a burden on your lifestyle and deter you from buying further properties or even force you to sell this one.
Advantages – there’s a silver lining and surprisingly it’s from Australian Tax Office (ATO). The ATO advises that ‘The overall taxation result of a negatively geared property is that a net rental loss arises. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income (such as salary, wages or business income) when you complete your tax return for the relevant income year’. So the major advantage is that a negatively geared property allows you to obtain a higher tax refund at the end of the year.
This advantage alone doesn’t necessarily make sense as an investor, so many investors hold negatively geared properties on the basis of ‘growth’. Growth allows you to build equity in the property and gives you the option of selling and making a profit or to access equity and buy further properties. As an example, Sydney properties increased by around 18% in 2015, though if we took a conservative figure of 6%, the property bought for $650,000 would have grown by $39,000 in one year, building you significant equity and softening the loss mentioned above.
Positive gearing is when you receive more in rental income than your costs of mortgage repayments, insurances, land tax and strata fees.
Advantages – the main advantage of this investment is that it doesn’t affect your lifestyle, so you won’t have any out of pocket ongoing expenses. Unlike negative gearing, positive gearing doesn’t put any added pressure on your financial circumstances if your household income dropped or your expenses increased. This would allow you to hold the property for much longer and in return hold out for more property growth.
With positively geared properties, you can continue to buy more as they should not cost you money to hold. This is very attractive to investors who want to hold a portfolio of properties. This investment type can look very attractive to the banks as it presents less of a risk to them.
Disadvantages – unlike negative gearing where you receive a tax refund from the ATO, positive gearing will mean you pay tax on the income you’re in receipt of from this investment property, which is very off putting for many taxpayers, especially high tax payers.
Even with interest rates at a record low, positive gearing investment properties in Sydney are scarce! You would find that positively geared cash flow properties are generally out of the CBD and in areas where there may be reduced growth. A great deal of research needs to be undertaken in choosing your purchase as a high yielding property is great, however you also need to ensure you have ongoing tenants to rent the property.
In a nutshell
Both investment types can work with your investment goals, however a full analysis needs to be undertaken in order to determine which one suits you best. Investing in property generally is a long term investment. Risk and reward play hand in hand with your strategy – a property in Sydney’s CBD would most likely have higher growth and lower vacancy rates than a property in the outer suburbs. However, due to the upfront and ongoing costs of the property in Sydney CBD, the rental yield would be much lower than the property in the outer suburbs.
There’s some speculation that negative gearing may be removed as it’s perceived as one of the causes of making home buying unaffordable for first home buyers. The removal of negative gearing should be taken into consideration if this is part of your investment strategy as it could place a further burden on your finances. You also need to take note of interest rates being as low as they are and allow for interest rate hikes, which most likely will result in a lower investment yield.
All the above is information only and no advice is given. Investing in property requires a lot of research and a consultation with a mortgage professional/financial planner and a tax accountant, and a real estate/property investment strategist could be very beneficial to your investment solution.
Raj Ladher is a local expert on mortgages and financial matters. Originally from the UK, his consultancy firm is now based in Sydney.