February 08, 2016
Lots of savvy property investors talk about gearing, negative and positive. If you are unsure as to what it all means, here is a fairly simple explanation.
Gearing basically means borrowing to invest. In this case, we’re talking about gearing in relation to investment properties. Most people have heard that negative gearing is good for the tax breaks - but first you should weigh up its impact on your own financial situation. Fill out our appointment form on this page to find out more, or read further
A negatively geared property is bought with a loan when the combination of annual interest repayments plus the deductible expenses associated with the property’s maintenance (e.g. using a real estate agent to manage your tenancy issues) exceeds the annual rent received from tenants of the property.
The benefit of such gearing is tax minimisation. The property upkeep and loan costs (such as interest) are allowed to be deducted from your annual wage or salary income, and then you are taxed only on that reduced amount. Herein lies the attraction of negative gearing.
For example, let’s say you own a rental property generating $25,000 in rent each year. The costs of holding the property, including mortgage interest, come to $30,000. This gives you a taxable loss of $5,000, which you can use to reduce the tax payable on your taxable salary income. Obviously, the higher the income you earn at work, the more you will benefit.
The more money you borrow to pay off a property, the more interest you will pay and therefore potentially the bigger the tax deduction you may receive. From a tax-saving perspective, although it may sound tempting to get the biggest loan possible to buy an investment property, you must remember that you still need the cashflow to meet those regular mortgage repayments even if there is no rental income coming in.
Other potential pitfalls of negatively geared properties include a situation where there is a dramatic downturn in property values and your investment fails to increase in value, or if interest rates rise very quickly and you have just agreed with your tenants that you will not raise rents for at least 12 months.
Positive gearing is the lesser known of the two types of gearing. This is where the annual rental income received from the property covers or is higher than the annual loan repayments and costs.
This is obviously of benefit to the purchaser because there are no out of pocket expenses in return for owning a property, and there is an expectation that the property will increase in value over the long term.
Of course, if you make money from positive gearing rather than just breaking even with costs, those extra dollars will be taken into account at tax time as income and you will be taxed on it according to the applicable tax scale. Regardless, you are making more money than you are being taxed.
For example, let’s say you receive $20,000 in annual rent but only spend $15,000 on the property including mortgage interest. In this instance, the difference of $5,000 represents profit and additional income to you as the landlord. As this profit is taxable, you have to set funds aside to cover the additional tax you will need to pay on your investment each year.
Typically, positive gearing is more common in conditions where you have bought a property well below market price or when the property is paying well above average in rental income (e.g. high rental demand areas).
However, be aware that it is much easier to find a property to negatively gear than find one to positively gear, considering the considerable purchase cost involved and the ability to typically get an investment property loan with only a 10% deposit (or less in some cases).
Note: The above explanation is not intended to be advice and should not be relied upon when making investment decisions. Always consult your mortgage broker and a tax specialist to obtain independent advice before making any financial decisions.
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