What the heck is negative-gearing?

So let's get into the basics: what is negative-gearing?

When an investor purchases a property, there is not only the initial cost of purchasing the house but also the ongoing costs associated with holding the property. These include aspects such as mortgage repayments, council fees, utility service charges, body corporate, property management, etc. When the cost of holding the property is greater than the rental income received, then the investor is effectively running at a loss. Thus, you are ‘negatively-geared’.

Why would anyone want to be negatively-geared?

Now you may be wondering, why would anyone want to make a loss on their property?

In Australia, the current government policy is that this loss, or difference between costs and rental income, can be used to offset against their taxable income, effectively reducing their pre-tax income and the burden of holding the property. In essence, negative-gearing is not really an investment strategy and more a tax strategy that can make investing in property far easier.

Of course, if you were losing money everyday while holding onto an asset, you would undoubtedly find it hard to sleep at night. However, many investors purchase knowing that they will be running at a loss even if they manage to secure relatively high levels of rental yield. Smart investors utilise negative-gearing as a long-term strategy to ease the financial and mental burden of investing – not only are they able to sleep at night, they are earning money while they do it by backing the Australian property market.

The long-term capital growth potential will hopefully outperform their immediate losses – that’s the long-term game that investors are playing. And quite frankly, when you realise that there has been a 412% increase in the growth of median house value in Australia compared to 25 years ago, negative-gearing starts to seem like a pretty good move.

How does negative-gearing work?

Imagine this: you manage to secure a property for $800,000. You pay an initial deposit of 20% ($160,000) and approach the bank to borrow the rest (which is $640,000). Your bank loans you the $640,000 at an interest rate of 5%, so annually you will be paying $32,000. For this example, we will assume there are no other costs associated with holding the property.

You then manage to find a tenant and charge them $500 per week. So annually you will be receiving $26,000 per year in rental income.

Subtracting your rental income ($26,000) from your holding costs ($32,000) for the property means annually you will have a rental shortfall of $6000. You are running at a loss and are essentially ‘negatively-geared’.

Through the current Australian policy of negative-gearing, you can apply this shortfall against your taxable income – essentially, reduce the amount of income that the government can tax. Et voila, you pay the government less tax and keep more money in your pocket!

Is negative gearing right for you?

It really depends on your appetite for risk and where you are buying. Before adopting any property strategy, analyse the risk and costs associated with holding the asset. Are you in a good enough financial position to bear the costs involved?

Get yourself an expert to cast their eye over your strategy, such as a financial planner or an accountant who specializes in property. Having the backing of professionals who really know their business will give you the best chance of avoiding falling any financial pitfalls.