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Negative gearing explained in simple terms

The great Aussie dream is first to own your own home and then to own another, which will grow your capital and hopefully assist you into another investment property to build wealth for your eventual retirement. There are a few ways to do this but today we will discuss the topic of Negative Gearing.

Simply put, when you negatively gear an investment property it means that the amount of rent you receive from the property over the financial year is less than the amount you need to pay on your mortgage to the bank which has been secured by the investment property.

There can be significant tax advantages if you can negatively gear an investment property. The costs of owning that investment property including any interest you pay on your mortgage each year, any property management fees paid to an agent as well as any repairs and maintenance costs are all tax deductible. At the end of the financial year when it’s time to lodge tax returns all of your outgoings related to your investment property can be offset against your total income (both from the property and any other source of income) to reduce the overall amount which will be payable to the tax man.

The bad side is that people often get over excited about the tax break and forget the risks involved.

For example, if an investment property is rented for $400 per week and your weekly mortgage repayment is $500 then over the year, the property will have a negative gap of $5,200. This is the amount of the tax deduction available to the owner, together with any additional outgoings required for the property. But while negative gearing does have great tax benefits, remember, it is still an investment making a ‘loss’ so you need to ensure that you have other income to supplement the repayments and to maintain the property through the duration of ownership. Remember a tax deduction only works for people who are paying tax and need the offset.

The key to negative gearing is this: never invest because of negative gearing. Treat it as a bonus, not a reason to invest. The owners of investment property are reliant on the capital growth/value of the property to increase substantially for when they want to sell the property, however, if the property market drops and there is little or no capital growth and the owner is in need to sell then in this situation he might wish he had reconsidered prior to structuring his investment in a negative manner eg. the recent slump in America when the property market crashed.

The key to turning the odds in your favour is to buy a quality property in a good location. The old adage to buy the worst house in the best street still rings true, as does the phrase location, location, location.

Try to purchase a property in a well-established area, where property prices are relatively stable, which will make you feel more confident of a reasonable return on your money when it comes time to sell. Taking a well-researched, cash-flow considered approach to negatively gearing an investment property can be a great way to invest, but always be informed of the risks involved.

If the rent paid by a tenant is not enough to support the cost of owning the property, then people are doing it in the hope that capital gains will rise every year, this may not be the case.

Lisa Montgomery of Resi says that even with the tax advantages of negative gearing, it won't suit all investors.

"There is always some risk associated with borrowing to fund an investment," she says. "If you overextend your borrowing, rising interest rates could restrict your ability to meet the loan payments."

Thanks to the AFR.

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To Your Success
Paul Zalitis
The Aussie Wrapper

 

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