Negative and positive gearing are popular terms in the property market. When it comes to investing, ‘gearing’ refers to borrowing to buy an asset. Both are considered investment strategies when taking out a loan to buy a rental property.
But why would anyone invest in something that is labelled ‘negative’? Well, it turns out that negative gearing is a well-known investment strategy amongst some investors.
What is a negatively geared property?
Negative gearing happens when the rental income you receive is less than the total costs of holding the property.
Also known as capital growth properties, negatively geared properties are expected to grow in value to be sold later for a profit.
Let’s break it down:
For example, let’s imagine that Michael purchased his first investment in Geelong, Victoria, for $490,000. Stamp duty and other costs came to $27,000.
Using the equity in his own home, he borrowed $517,000. To avoid cross securitizing the properties, he borrowed the total amount in two separate loans:
- $400,000* at an interest rate of 4% secured to the property in Geelong. Repayments = Interest only: $1,334 a month.
- $117,000* at an interest rate of 4% secured to his existing home (the equity release). Repayments = Interest only: $390 a month.
Michael’s total interest repayment is, therefore, $1,724 a month.
Other monthly costs of the property, such as rates, maintenance, landlord’s insurance, and real estate agent fee, added $446 a month to the math—the costs of holding the property now come to $2,170.
The rental income from this property was $350 a week or $1,517 a month.
As the rental income is less than what Michael is spending on the property, this property is said to be negatively geared by $653 a month or $7,836 a year.
So why would Michael invest in a negatively geared property?
Because he can use that ‘loss’ to reduce his taxable income and how much tax he has to pay.
How come?
Michael’s salary is $150,000 a year. Tax payable on this is about $43,567.00 at the time of writing.
After purchasing the property, Michael makes a ‘loss’ on the investment property of $7,836 a year. This works to reduce his taxable income down from $150,000 to $142,164. Tax on $142,164 is $40,510, resulting in a savings in tax of $3,057 a year.
Therefore, the actual cost to Michael to buy this investment property is $4,936 a year or $4,779 a year or $91.90 a week.
What is a positively geared property?
Positive gearing happens the rental return from your tenants is more than the total expenses of owning the property.
Also known as cash flow properties, positively-geared properties are usually found during periods of strong rental demand and low-interest rates.
Let’s go back to Michael’s example:
Now let’s consider that the property that Michael purchased was a duplex with a rental income of $650 a week/$2,816 a month. Other monthly costs of the property, such as landlord’s insurance and real estate agent fees, would go up slightly, so let’s presume total costs are now $2,441 a month.
As the rental income is now more than the costs, this property is said to be positively geared by $375 a month/$4,500 a year.
Michael has to add this to his taxable income, though. This results in his taxable income being $154,500 with tax payable of $45,322, an increase of $1,755 a year.
Including tax, this investment property is making Michael $2,745 a year or $54.50 a week.
So, which one is better?
As you can see in the examples above, there are a lot of factors to consider when buying an investment property.
As with all investments, your strategy should be aligned to your personal circumstances and risk preferences.
Besides the numbers, there are other essential questions you need to ask yourself:
- What happens if you can’t secure tenants at any one time?
- What if interest rates rise and you have a fixed-term agreement in place?
When choosing which type of investment property is the best, the decision ultimately rests with the investor and the strategy and risk you are willing to accept.
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*Loan term: 30 years with a 5-year interest-only period.
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