NEGATIVE AND POSITIVE GEARING – THE BASICS EXPLAINED AND FACTORS TO CONSIDER
There are many pros and cons to investing in different types of real estate. But first you must understand the definitions of different types of investment properties. All these terms relate to how a property affects your cash flow on an ongoing basis.
Negative Gearing
The term negative gearing is thrown around quite a bit in the world of property investing. So what does it actually mean? Put simply, negative gearing means that the cost of holding the investment property is greater than the income (rent) the property receives. It is this loss that you can claim to lower your taxable income (and therefore reduce the tax that you pay).
As an example, John has an investment property in Melbourne and the cost of holding the property is $2,000 each month which comprises of:
Interest repayment on the loan $1,500
Property management fees $100
Insurance $50
Rates $100
Maintenance $50
Depreciation $200
Total costs per month = $2,000
John also collects $1,500 per month rent.
Therefore:
Total investment property costs $2,000
Total investment property income $1500
Total cost per month= $500
Therefore, John’s Canberra investment property is negatively geared by $500 per month or $6,000 per annum. This $6,000 per annum gets taken off John’s annual taxable income.
So if John’s taxable income was $50,000. It would now be reduced to $44,000 ($50,000 minus $6,000).
Now John can either wait until the end of the financial year to claim his tax refund (as he would have paid tax on the entire $50,000 throughout the year) or he can apply to the ATO to take out less tax each time he gets paid. This way, his tax return is effectively spread out over the financial year instead of being delivered in one lump sum at the end.
Positive gearing
The term positive gearing is also thrown around quite a bit in the world of property investing. Put simply, positive gearing means that the income (rent) the property receives is greater than the cost of holding the investment property.
So if we took John’s example from above and changed the rent received from $1,500 to $2,500 you will see that he is actually making a profit of $500 per month from his investment property. The breakdown would be as follows:
Total investment property costs $2,000
Total investment property income $2,500
Total income per month= $500
This amounts to an additional $500 per month to John’s taxable income or $6,000 per annum. This means that John’s new taxable income is $56,000 – meaning he will have to pay tax on the additional $6,000 that his investment property has earned.
Negative or positive gearing – which is best?
There’s no right or wrong – what works for one person may not work for the next.
The general argument is that negatively geared properties generally achieve higher capital growth but lower rental yields while positively geared properties experience lower capital growth but higher rental yields.
Why’s that? Again, this is generally speaking, but properties that achieve high capital growth are thought to exist in major metropolitan areas where the value of the property is high in comparison to the rent it receives. On the flipside, it’s generally believed that positively geared properties are in regional or fringe areas of cities where the properties achieve high rents in comparison to the value of the property.
Of course there are exceptions to these rules – and both positively geared properties which achieve decent growth can be found. Margaret Lomas has an excellent book titled 20 must ask questions which identifies a number of key factors that lead to this outcome.
Some factors to consider about either strategy.
Hitting a serviceability wall quicker with negatively geared properties
An issue that some investors don’t consider early on is that properties which are negatively geared can quickly put a halt to their ability to purchase more properties. Why? Because these properties cost you money to hold – therefore reducing your capacity to accumulate more.
A negatively geared property needs to increase in value at rate greater than the cost of holding it
It goes without saying. A property that is costing you money to hold must increase in value at a rate higher than the cost of holding it.
Turning a negative into a positive
There are lots of creative ways that can increase the rent your investment property receives – which improves the rental yield of a property. These include renovations, allowing the tenants to keep a pet or adding an extension/granny flat that will allow the property to generate an additional income stream.
You will need to pay tax on the income your positively geared property generates.This really shouldn’t be seen as an issue as it means that you’re making money – which is never a bad thing.
If you’d like to know more, please contact us for a FREE no obligation consultation on 03 8390 5855 or email mitesh@thinkandgrowfinance.com.au