Negative Gearing: What It Is & How It Really Works?

Negative gearing has long been a central topic in Australia's property investment world. For some, it is a smart tax strategy that builds wealth. For others, it is a controversial policy that increases property prices.

In simple terms, negative gearing happens when the costs of owning a property, such as loan interest and expenses, are higher than the rental income earned. The loss can then be used to reduce taxable income.

It is a strategy often discussed with both accountants and mortgage brokers, since borrowing costs play a central role in how it works.

What Is Negative Gearing

Negative gearing occurs when the expenses linked to an investment property are greater than the rental income it generates. This means the investor is running the property at a loss.

Typical deductible expenses include:

• Mortgage interest
• Maintenance and repairs
• Insurance premiums
• Property management fees
• Depreciation of assets

These losses can be offset against other taxable income, reducing the overall tax liability. The long-term expectation is that the property will increase in value enough to outweigh the short-term losses.

How Does Negative Gearing Work?

The process of Negative Gearing can be bifurcated into multiple pointers, which assist in understanding the workings of Negative Gearing thoroughly:

1. Acquiring a Property: The process starts as and when an investor makes a purchase, specifically by acquiring a loan or on lease. The main intent behind this is to earn rental income as the property owner earns long-term rental income and awaits the overall value appreciation for the property.
2. Operating Costs: As you own the property, the investor has to bear distinct expenses, including interest payments, mortgage rates, property brokerage fees, maintenance costs and premiums, along with the overall depreciation rate of the property and the fixtures within.
3. Income vs. Costs: Let's understand it through an example, wherein the overall cost of the above-mentioned expenses exceeds the overall rental income, then the property qualifies for being negatively geared.
4. Tax Deduction: This loss can then change the other taxable income, such as wages or the overall profits churned out of the business.

While this strategy directly impacts the cash flow, most investors consider negative gearing as a positive move as it brings potential value appreciation in real estate.

Example

Rental income: $20,000 per year
Loan interest: $22,000 per year
Other expenses: $5,000 per year

Total expenses = $27,000
Rental income = $20,000
Net loss = $7,000

This $7,000 loss can be deducted from the investor's other income, lowering their tax bill. If the property increases in value over time, the long-term gain may outweigh the short-term losses.

For more on handling future property gains, see this guide on capital gains tax.

Pros of Negative Gearing

As mentioned above, Negative gearing can bring in several advantages that make it attractive amongst real estate dealers or investors in Australia.

• Tax Relief:

  The first benefit here is the Tax relief offered by Negative gearing. Because of its ability to offset property losses majorly, it results in significant tax savings annually. It is most beneficial, especially for people who are high-income earners. This assists them in reducing their tax liability towards the government, impacting the Australian government economy directly.

• Encourages Investment Activity:

  Since Negative Gearing helps to mitigate financial losses to a major extent, it gives you the strength to enter the real estate market, leading to a broader economic prospect.

• Long-Term Wealth Creation:

  Some ample investors have an eye for long-term capital gains and are fine with enduring short-term losses; negative gearing acts as a perfect solution to all of them. Since property rates have increased over the years, investors have been able to build an economy that is stable and sound. It acts as a positive booster point for the Australian Economy.

• Economic Contributions:

  Negative gearing also contributes to the Australian economy by fostering real estate industrial growth and connecting industries, such as construction, property management and financial services. This ripple impacts the overall economy of a country/state.

• Diversification of Portfolio:

  Property is considered to be a tangible asset. This asset can help in balancing the class and risks associated with volatile investments such as Blockchain, Cryptocurrencies, Stocks and more.

Investing in Property can be a profitable venture compared to volatile investments; hence, because of this feature, Negative gearing is considered a boon to the economy.

Drawbacks of Negative Gearing

We have discussed many pros of Negative Gearing, but there are several Cons attached to it, a few of them include:

1. The concern of Affordable Housing:

   There are critics who have argued that the negative gearing inflates the overall property prices as the demand increases. This brings in a challenge, especially for investors who are investing in property for the first time.

2. Unequal Distribution of Benefits:

   As discussed above, the majority of tax benefits are taken by people who are in the high-income bearing category and can avail themselves of the benefit of buying multiple properties at once. This brings disparity in the tax system and unequal distribution of income.

3. Impact on Government Revenue:

   Since Negative Gearing allows a tax deduction on property losses, the government revenue is reduced at par, resulting in monetary loss.

4. Market Distortions:

   One disadvantage of Negative gearing is it creates investment patterns. This boosts the real estate market and brings in profit of all kinds; on the other hand, the technology and transportation sector is lagging because of it creating a distorted market.

Implications for Australia's Real Estate Market

Negative gearing has many implications, specifically for Australia's real estate market. Listing a few may include but are not restricted to:

1. Boosting Investor Demand: Negative Gearing's policy is known to incentivize property rates, specifically in areas such as Sydney, Canberra and Melbourne. This demand supports and stimulates the development of the real estate industry.
2. Stability it brings in the Rental market:As the negative gearing encourages investment in real estate, especially in rented properties, it creates stability and a steady atmosphere for renters, addressing accommodation for those who are either not able to or unwilling to purchase a home for some reason.
3. Pressure on Property Prices: It has increased competition amongst investors, leading to inflation of prices in the real estate market. This inflation causes disruption, especially among people who are dealing in the real estate market for the first time.
4. The challenges involved with Urban Planning:Since Urban areas are amongst the most sought-after, the activity in such areas is high, resulting in straining existing infrastructure. This highlights the overall need for well-planned urban planning.

Negative Gearing and Taxation Policy

Negative gearing remains one of the most debated parts of the Australian tax system. The government allows investors to deduct net property losses from their other taxable income, but this has been criticised for its impact on affordability and equity.

For further reading, see the Treasury's review of negative gearing.

Who Should Consider Negative Gearing?

Negative gearing can be a powerful strategy, but it is not suitable for everyone. It often benefits high-income earners the most, since they can take advantage of larger tax offsets by deducting property losses from other income. Investors with strong and reliable cash flow are also better placed to manage the ongoing shortfalls that come with negatively geared properties.

The approach works best when investors have a long-term plan focused on capital growth, as property values need to rise significantly to justify years of losses. On the other hand, first-time buyers or those with tight budgets may struggle to keep up with the costs, making negative gearing a less suitable option for them.

Long-Term Strategy and Risks

Negative gearing is designed as a long-term strategy where investors accept short-term losses in the hope of long-term capital gains. The idea is that property values will rise enough over time to outweigh the yearly cash flow shortfall. However, this comes with risks. Covering ongoing losses can put significant pressure on an investor's finances, particularly if their income is not stable. Rising interest rates can worsen the gap between expenses and rental income, while a market downturn may reduce or eliminate potential gains altogether.

For these reasons, negative gearing requires careful planning, financial discipline, and a strong risk appetite before being adopted as part of an investment strategy.

Exploring Alternatives to Negative Gearing

So, we have discussed the advantages, disadvantages and benefits it brings for the Australian economy. Let's understand what the possible alternatives to Negative Gearing are. A few of them include but are not limited to the following:

• Positive Gearing: When we invest in properties with the main objective of rental income, which may exceed expenses and bring in regular cash flow along with a reduced financial strain.
• Diversified Investments: This is an intelligent strategy for investors, as one should invest in diversified objects. Try and diversify your portfolio to stocks, bonds, mutual funds and other components to mitigate risk.
• Real Estate Investment Trusts (REITs):REITs are investment trusts that help you to understand the pros and cons of the real estate market without actually investing in it. This is an excellent alternative to understanding the challenges of Negative Gearing.
• Commercial Property Investments: Another alternative to Negative Gearing could be to invest in Commercial properties rather than Residential Properties. This is because commercial properties tend to be less prone to risk and can be safely accumulated for better results.
• Eco-Friendly Investments: The next in line is investing in sustainable projects. This can turn beneficial because these properties have sustainable development and offer long-term value appreciation.

Negative Gearing vs Positive Gearing

Here's a simple comparison of the two strategies:

The Big Question: Is Negative Gearing Perfect for You?

The answer is a topic of debate in itself. However, potential investors should consider a few things to understand whether Negative Gearing can be beneficial for you or not.

• Financial Preparedness: Analyse and understand the overall cash backup to work up for the short-term losses. If you can bear the same without hassles, then Negative Gearing can turn profitable for you; if it is vice versa, then Negative Gearing may not be the right option.
• Market Research: Research, Review, and recognize the overall market to understand the market dynamics and the growth prospects. Don't rush into making decisions, as capital growth is a time-consuming and calculated risk analysis process.
• Professional Advice: Don't shy away from seeking guidance from financial advisors, as they are experts and may help you set ideal and realistic goals accordingly.
• Long-Term Vision: Remember, Negative Gearing is a Long-term Profit Venture and may not reap early returns. If you have the time to see your property value appreciate over the years, then go ahead; otherwise, stay back and invest.
• Risk Management: Mitigating risks is a profitable venture; hence, diversify your investment in a range of products.

FAQs About Negative Gearing

For broader tax considerations, review this guide on property tax.

Conclusion

In simple words, I can say that Negative Gearing is a game changer, especially in shaping Australia's real estate and economic landscape.

However, it brings the challenge of waiting extensively until the long-term value of a property appreciates.

Irrespective of whether you are an investor or a first-time home buyer, you should weigh the pros and cons of negative gearing thoroughly according to your case, then proceed.