The term ‘gearing’ simply means borrowing to invest. When it comes to buying a rental property, most people achieve gearing through their investment loan.
Three types of gearing
Not all rental properties are negatively geared.
A property is said to be ‘positively’ geared when the rental income is greater than the costs of owning the place. These costs can include repairs and maintenance, insurance, council rates, and depreciation of new items such as air conditioners or carpets. When you borrow to invest, the cost of loan interest also goes into the mix.
‘Neutral’ gearing means the rent exactly covers the property’s outgoings.
It is ‘negative’ gearing that tends to attract the most attention. This refers to the situation where there is a shortfall between the investor’s rental income and the expenses associated with owning the property.
Negative gearing can offer tax savings
Why would anyone hold onto an investment that continually makes a loss? The answer lies in the potential for tax savings.
To understand how it works, let’s take a look at a hypothetical investor – Sam.
We’ll say that Sam buys an investment property using a $400,000 loan. He receives $15,000 in annual rent and his various property expenses including loan interest, add up to $25,000 each year. This means that Sam’s rental property leaves him out of pocket to the tune of $10,000 annually.
Sam is able to claim the $10,000 loss as a tax deduction. This can lower the tax on his regular salary income, which helps to make the cost of the owning a rental place more manageable.
For instance, if Sam’s annual salary is $95,000, he would normally pay tax totalling $23,6171. However, his rental property loss of $10,000 reduces his taxable income to $85,000. This in turn lowers his annual tax bill to $19,792 – a saving of $3,825.
Capital growth makes up for ongoing losses
Even with the tax savings of negative gearing, our investor Sam doesn’t appear to be making money on his property from year to year. However, what this example doesn’t show is that Sam’s investment property should rise in value over time. This gives Sam the potential to sell the place at a profit in the future. Ideally, the long term capital growth will make up for the annual shortfall in rent.
For many investors, the prospect of capital gains (which are comparatively lightly taxed) plus the ongoing tax breaks of negative gearing are the real points of appeal behind owning an investment property.
To understand whether gearing – and negative gearing in particular – is a strategy that can help you achieve your goals, speak to your local Mortgage Choice expert.
1 Assumes 2018/19 personal tax rates. Includes Medicare levy.