When it comes to investing, the term 'gearing' refers to borrowing to buy an asset. Most investors use some gearing in the form of their mortgage, to fund their rental property.
Negative gearing occurs when the cost of owning a rental property outweighs the income it generates each year. This creates a taxable loss, which can normally be offset against other income including your wage or salary, to provide tax savings.
Let's say for example that Bill owns 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 Bill a taxable loss of $5,000, which he can use to reduce the tax payable on his salary.
If you know in advance that your investment will record a loss over the financial year, you can apply to the Tax Office to reduce the amount of tax taken out of your salary. This is called PAYG Withholding Variation and it can provide a real boost to your personal cash flow. You can chat with your mortgage broker about options and with a tax advisor or accountant for more details.
Gearing often plays a significant role in all investors strategies. Knowing your investment strategy is important, and getting expert financial advice is smart if you need help identifying the right approach to maximise your profits.
Risks associated with negative gearing
While there are some certain benefits associated with negative gearing, it isn’t without its pitfalls.
When you negatively gear your property, you still record a loss. And a loss is a loss is a loss. Before you commit to negatively gearing your investment property (or multiple investment properties) it is worth considering what the repercussions of doing so are.
- What happens if you have difficulty filling your rental property at any one time?
- What if there is a dramatic turn down in property values and your investment fails to increase in value?
- What 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?
These are not questions that should be answered quickly or treated lightly. Take the time to do your due diligence and know how you would cope if any of the above scenarios came true. If you are confident that you could easily handle any losses in income etc, then you are on the right track.
Of course, if you do choose to negatively gear your property, there are some easy ways for you to minimise the risks associated with doing so.
Minimising the risks of negative gearing
- Choose your investment property wisely: Buying a property that is located near all the major amenities and appeals to a wide range of tenants should help you to ensure your investment property is never vacant for very long.
- Manage your income: When managing an investment property, there are times when it will cost you a significant amount of money – when the property is vacant, when it needs repairs etc. So, before deciding on negative gearing make sure you have enough income to successfully manage all the expenses that come with owing a property – not just day to day expenses, but all expenses.
- Protect yourself and your investment: As a property investor, it is critical that you adequately protect and insure not only your property, but yourself in the event that unforeseen circumstances arise. It never hurts to be prepared for the worst case scenario. You can speak to your mortgage broker or financial planner to learn more about the types of insurances you should have as a property investor.
Negatively gearing an investment property is not a decision that should be made lightly. We can step you through the whole process, identify the risks associated with negative gearing and help you formulate a plan to not only minimise the risks, but tackle any hurdles that you may face during your investment journey.
An investment is positively geared if it earns more in rental income each year than it costs to own the property.
For example, a landlord may 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 the landlord. As this profit is taxable, landlords of positively geared properties need to set funds aside to cover the tax they will pay on their investment each year.