Negative gearing is one of the most common things clients ask us about. We have written about it before – but the questions are so persistent we thought we should cover it again this week.

Gearing means borrowing to make an investment. We use the term gearing because borrowing acts on investment the same way gears work on an engine. In an engine, gears allow greater speed for a given number of revolutions. In borrowing, gearing allows a larger return for a given amount of your own investment money. You need to be a little careful here, however. When we say that gearing makes for a larger return, this happens to both positive and negative results. If an investment loses money, and you have borrowed money to make some or all of that investment, your loss will be bigger than if you hadn’t borrowed at all.

Strangely, that’s not where the ‘negative’ comes from in the term ‘negative gearing.’ When you borrow money, you need to pay interest. If the interest expense, plus other expenses of holding the asset, exceed the return you receive while holding the asset, you make a short-term loss. It is this loss that leads to the term negative gearing. It’s probably best understood with an example:

Rebecca has $100,000 to invest. She borrows another $300,000 and buys a $400,000 investment property. The interest on her borrowing is 5%, or $15,000 per year. There are another $5000 worth of holding costs, such as council rates and insurances. Altogether, it costs her $20,000 per year to hold the property.

Rebecca rents the property to a tenant for $350 per week. The managing agent takes 7% of this, leaving her with $325 per week. For the full year, Rebecca receives $16,926 in rent.

This means that Rebecca loses $3074 each year (costs of $20,000 minus $16,926 in rent). Because she has used gearing and she has made a loss, this situation is known as negative gearing.

Why use negative gearing if it means making a loss?

When an investment asset is negatively geared, the asset holder loses money in the short term. This only makes sense if the investor is very confident that he or she will make that money back over the medium to longer term. Generally, this happens with an increase in asset prices. For example, if Rebecca’s investment property in the example above appreciates at 3% per year, she will enjoy capital growth of $12,000 in the first year. This is more than the loss she has made. So, when she eventually sells the asset, she is hoping that the capital growth will more than compensate her for the short-term loss that she has experienced.

Once again, it only makes sense to use negative gearing if you are very confident that the asset you purchase will increase in value over time.

As a general proposition, people tend to be more likely to negatively gear property assets than other assets such as share portfolios.

Negative gearing and tax

If the investor has other taxable income, they can often offset that income with the loss they have made on their investment. Again, returning to Rebecca’s example above, she could reduce her taxable income by $3074 in the first year. This means she will pay less tax. How much less tax she pays depends on her tax rate. If her tax rate is 39%, then she will pay approximately $1200 less tax. This reduces the actual out-of-pocket loss to just $1800.

Many people criticise this aspect of Australia’s tax system, arguing that gives an unnecessary and unfair advantage to investors when compared to wage and salary earners. Whether this is the case or not, the fact is that negative gearing has been available in Australia for a very long time and has proved quite resistant to political change.

Occasionally, we come across somebody who has made an investment in a negatively geared asset specifically to reduce this year’s tax bill. Put simply, that is never a good idea. Negative gearing should only ever be used when an investor is confident that medium to long-term capital growth for more than offset the short-term losses associated with holding their asset.

Negative gearing can be complicated. If you are considering it, please talk to us first. It is important that everything happen in the right order if you are to meet all the requirements of the tax office and select a sensible investment asset in which to invest.