Negative gearing is a financial strategy that's both a big topic and a common practice among property investors, especially in countries like Australia. While we’re not here to give our hot take on the subject, we are here to help you better understand common investing terminology. So without further ado, here’s our explainer on negative gearing.

What is negative gearing?

Negative gearing is an investing strategy which occurs when the costs of owning and maintaining a rental property exceed the income it generates. Essentially, it's when your expenses are higher than your earnings from rent, resulting in a loss.

That might not seem to make much sense, however, that loss can be used to reduce an investor’s taxable income, potentially leading to a tax deduction. Many investors are drawn to negative gearing not only for the tax benefits but also for the potential long-term gains as property values increase.

The strategy is particularly popular in real estate markets like Australia, where favourable tax laws make it an attractive option for investors.

How does negative gearing work?

To grasp negative gearing, it helps to understand gearing in general. In the context of property investment , gearing means using borrowed funds to purchase investment properties. It can be positive, neutral, or negative, but we’ll get to the differences between the three shortly.

In a negatively geared property, the rental income falls short of covering all the expenses associated with owning the property. These expenses include mortgage interest payments (but not principal payments), property management fees, maintenance costs, insurance, council rates, and depreciation.

So why would anyone choose to lose money? The primary motivation is the potential tax benefits. The ability to deduct the loss from other income can lead to significant tax savings, especially for high-income earners.

For example, if an investor earns $20,000 annually in rental income but incurs $30,000 in expenses, they experience a $10,000 loss. This loss can then be used to offset other taxable income, such as salary or business profits, thereby reducing the investor’s overall tax liability.

Moreover, investors are betting on long-term capital gains. They anticipate that the property’s value will appreciate over time, making up for the short-term losses with substantial profits down the road.

Another reason investors employ negative gearing is portfolio diversification . By investing in property, they spread their risk across different asset classes , potentially enhancing the stability of their overall investment portfolio. Real estate is often seen as a stable and tangible investment compared to the sometimes volatile stock market.

Why did the government introduce negative gearing in the first place?

The Australian government introduced negative gearing in the 1930s to try to invigorate the housing market and boost the economy. By allowing investors to deduct rental property losses from their taxable income, the policy made property investment more enticing. This, in turn, aimed to increase the supply of rental properties, helping to ease housing shortages and keep rents affordable.

The government envisioned negative gearing as a strategy to draw private sector investment into residential real estate, thus lessening the burden on public housing and infrastructure. The tax incentives were crafted to encourage long-term investment in property, promoting a stable and expanding housing market.

While the policy has successfully attracted investment, it has also sparked ongoing debates about its impact on housing affordability and the broader economic landscape. Negative gearing remains a hot topic, balancing economic stimulation with its effects on the real estate market.

Does negative gearing only apply to property?

Negative gearing is most famously linked to property investment, but it’s not confined to real estate alone. It can also be applied to other investments, such as shares and managed funds .

Imagine borrowing money to invest in shares, where the dividends and returns don’t quite cover the interest on the loan and other expenses. Just like with property, this shortfall can be used to offset other taxable income.

Is there such a thing as neutral or positive gearing?

There sure is!

Neutral gearing occurs when the income generated from an investment property matches the expenses of owning it. Essentially, the property breaks even, covering costs like mortgage payments, maintenance, and management fees without creating a profit or a loss.

Positive gearing, on the other hand, is when the income from the investment exceeds the expenses. This means the investor enjoys a surplus, resulting in a profit. Positive gearing is often seen as less risky than negative gearing because the investment generates an immediate return. However, it may come with higher tax liabilities since the profits are subject to taxation.

For anyone considering negative gearing in their investment journey, what are the risks to consider?

Negative gearing can be a tempting strategy, but it's not without its risks. The biggest gamble is banking on future capital growth . If your property or shares don't appreciate as expected, you could be staring down the barrel of prolonged financial losses. Markets are unpredictable, and property values or share prices can swing dramatically.

Another concern is cash flow. Since negative gearing means your expenses exceed your income, you'll need to cover that shortfall from other sources. This can be tough if your property sits vacant or if dividends from shares aren't as hefty as anticipated. Plus, unexpected costs like maintenance or rising interest rates can throw a wrench in your financial plans.

And then there’s the wild card: tax law changes. Governments can tweak tax policies, potentially slashing the benefits of negative gearing. This could seriously impact your investment's profitability.

In short, negative gearing is a popular yet intricate investment strategy. It offers potential tax benefits and the promise of capital gains but also carries significant risks.

As an investor, it’s absolutely worth carefully considering your financial situation, market conditions, risk tolerance , and long-term goals before diving into the world of negative gearing. Reach out to a licensed financial adviser for further support. And because negative gearing carries tax implications, make sure you chat to a tax accountant if you need advice.