Property Investing Basics - Understanding Negative Gearing
Have you been considering investing in property? Chances are that you’ve probably heard the terms ‘negative gearing’ and ‘positive gearing’ floating around, as they are synonymous with property investment.
Here is an overview of negative gearing, the types of investors who use it and an summary of the risks
Have You Considered Negative Gearing?
Have you been considering entering the real estate market? Chances are that you've probably heard the terms 'negative gearing' and 'positive gearing' floating around,
Given that very few of us can afford a rental home out of our own pocket, borrowing funds to make the purchase is an inevitability for most. In fact, according to the Australian Bureau of Statistics (ABS), there is around $13.5 billion worth of housing investment within our nation every month.
A home loan will allow you to commit to a bigger venture, enabling you to take advantage of potentially boosted profits because you will have more of a capital base to earn returns on. This is essentially what negative and positive gearing is - purchasing a home with an amount of money that has been geared up by finance.
What's the Difference Between Positive and Negative Gearing?
When it's boiled down, positive gearing is simply when the annual rental income you receive from your investment exceeds the costs of owning it. Meanwhile, negative gearing is the exact opposite.
For example, John was employing negative gearing as his rental property generated $25,000 in rent each year, while the expenses of ownership came to $30,000. These costs can include:
- Borrowing costs like valuation fees, loan estabilishment fees, lenders mortgage insurance premium
- Interest payments and ongoing loan fees
- Property management fees
- Advertising for tenants
- Accounting fees
- Council rates
- Repairs and maintenance, pest control, cleaning and gardening
- Any legal expenses
- Depreciation of items such as stoves, fridges plus the building
It's important to note that these are just the constant costs, there can sometimes be unforeseen scenarios where you will have to stump up with more money, such as an increase to council rates or rental vacancies.
Why do Investors Use Negative Gearing?
In an ideal world, you would be able to purchase a home that produces enough rental yield to cover your mortgage repayments and any other associated costs. While this scenario is a reality for some investors, what if interest rates were to suddenly rise or your tenants leave without paying rent?
The Australian Taxation Office (ATO) affirms that should a loss be made on your rental, the principles of negative gearing can step in to soften the blow by allowing you to offset that loss against another source of income.
In John's case for instance, he lost $5,000 over the year on his investment, which means that he can take this loss off his primary income to end up with reduced taxable earnings. This is not to mention the various tax deductions you are entitled to claim on your property as an investor, like council rates, repairs, real estate agent fees and insurance, among others.
The end goal for investors like John is to weather the costs in the short term, while benefiting from the capital gains in the long term. The method is certainly popular, as the Property Council of Australia (PCA) found that around two thirds of residential property investments are negatively geared.
What Kind of People are Using Negative Gearing?
There is a common perception that negative gearing is just a tax benefit for the wealthy and that it should be abolished. However, research from the PCA revealed that over two thirds of investors who benefit from negative gearing, in fact, earn a taxable income of less than $80,000.
This group included:
- 53,855 teachers
- 42,460 construction and tradesmen
- 22,625 hospitality workers
- 35,910 midwives and nurses
PCA Chief Executive Officer Ken Morrison believes it's clear that negative gearing is actually largely to the benefit of middle Australians.
"They tick all the boxes by increasing supply, giving people an opportunity to get into the housing market and helping ordinary Australians build wealth for their future," he said.
Are There Any Risks?
Despite there being a range of benefits to negative gearing, there are a few pitfalls to be wary of. Before you make any financial commitments, the Australian Securities and Investments Commission recommends thinking about the repercussions and asking yourself a few questions, which include:
- What will you do if you're unable to fill your rental property?
- What if the market crashes and your investment doesn't increase in value?
- What will you do if interest rates suddenly rise but you're unable to raise the rent due to a signed contract with the tenants?
Furthermore, while it may be obvious, it's certainly worth noting. In order for negative gearing to have any benefit to you as an investor, you must have another source of income that you can offset your losses against.
Of course, you can minimise the risk by simply doing your due diligence, and:
- Scour the markets for a property that is likely to increase in value
- Ensure you have financial reserves for any possible periods of no rental income or other unexpected costs
If you would like assistance climbing the ladder talk to your financial advisor. If you would like assitance managing your property, you should employ the services of a real estate agent as they will be able to help you make an informed investment.