Negative gearing is one of the most misunderstood concepts in income tax, often mentioned in the media without adequate explanation.
This article aims to demystify negative gearing and compare it with positive gearing, providing clear and practical insights.
Let’s get straight to the point
Negative gearing involves borrowing to invest, where the costs of the investment (including interest) exceed the income it generates.
This loss can be deducted from your taxable income, potentially providing a tax refund. Investors often use negative gearing with the expectation that capital gains will eventually offset these losses.
Positive gearing, on the other hand, occurs when the income from an investment exceeds its expenses. This scenario provides positive cash flow but can take more work to achieve, often requiring lower initial borrowing or significant debt repayment.
Both strategies have their benefits and risks, and understanding them can help investors make informed decisions based on their financial goals and current economic conditions.
Understanding Gearing
Gearing simply means borrowing to invest. It allows you to invest more than your current capital, potentially increasing your profits if the investment succeeds. Conversely, it also magnifies your losses.
What is Negative Gearing?
Negative gearing involves using interest costs as a deduction against the annual taxable profit of the asset. Let’s use an investment rental property as an example, which is the most commonly geared asset:
1. Calculating Negative Gearing:
- After considering tenant income and adding the property costs (rates, water, repairs, advertising, real estate commission) to the interest paid for the year, an investor will typically end up with a negative figure.
- This negative figure means you have paid actual cash out of your bank to keep the rental property afloat.
- This out-of-pocket cost can be used as a tax deduction against your salary and wage income, saving you income tax.
Why Would You Want an Investment That Makes a Negative Gearing Loss?
While making a loss on an investment might seem counterproductive, some investors do this, believing the capital gain upon selling the asset will more than offset the accumulated losses.
1. Capital Gains Tax Concessions:
- Capital gains income tax concessions are available for assets owned for more than 12 months, allowing investors to deduct losses fully but pay tax on only half the profits.
2. Applicability Beyond Property:
- It is not only investment properties that can be negatively geared. You can borrow money for any investment – shares are often used because the franking credits and dividend yield can make them more attractive than property for those who can outperform the stock market.
3. Tax Refund Potential:
- In the current income tax system, a negatively geared investment can provide a cash tax refund of anywhere between 19%-47% of the loss. This can cushion the blow and help you pay off the loan faster.
What is Positive Gearing?
Positive gearing occurs when your rental property expenses (including interest) are less than your tenant income. Using an investment rental property as an example again:
1. Calculating Positive Gearing:
- In this scenario, you can use the rent to cover all expenses and still have money left over.
2. Achieving Positive Gearing:
- To achieve positive gearing, you need to either borrow less initially or repay a significant portion of the debt.
Conclusion
We have extensive experience in rental property deductions, from depreciation to interest to repairs. Recent changes regarding travel deductions require careful consideration, and we can help guide you through these complexities.
If you need guidance on deductions or are considering changing accountants, please call us on (03) 8568 3606. With over ten years of combined experience working with a diverse range of clients, Bookkept is well-equipped to assist your business. We offer personal and business tax services and are dedicated to helping you succeed.
Frequently Asked Questions
How does Positive Gearing affect my tax?
With positive gearing, the profit from the property is added to your taxable income, which can increase the amount of tax owed. However, because the property generates profit, the investor doesn’t need to cover any shortfalls.
Which is better: Negative or Positive Gearing?
There’s no one-size-fits-all answer. Negative gearing might benefit those aiming for long-term capital growth and potential tax benefits, while positive gearing is more suitable for those looking for regular income. The decision depends on your financial goals, income level, and risk tolerance.
Can I switch from Negative to Positive Gearing?
Yes, an investment property can shift from negative to positive gearing over time, especially as loan repayments decrease or rent income rises. This transition is common as investors pay down their mortgage or as property market conditions change.
Is Negative Gearing only available for property investments?
No, negative gearing can also apply to other types of investments, like shares, where expenses (such as loan interest) exceed the income earned. However, it is most commonly discussed in the context of property.
What are the tax implications if I sell a negatively geared property?
If the property is sold for a profit, capital gains tax (CGT) applies. However, if held for more than a year, the investor may qualify for a 50% CGT discount. A loss on the sale could be used to offset capital gains from other investments.
