The negative gearing strategy requires investors to accept income loss in exchange for tax benefits, but while it is often linked to real estate investments, the approach is not limited to properties.
Here’s a quick guide to explain why investors still consider the strategy in spite of income loss.
What is ‘gearing’?
The term ‘gearing’ refers to the strategy of borrowing money to purchase an investment, regardless of its asset class. However, investors may link gearing strategies to real estate investments because it is often used to purchase rental properties.
There are three ways to gear investments: positive, neutral and negative. Their difference lies in how income compares to the loan interest rate.
- Positive gearing refers to an investment property whose net income exceeds the loan interest rate which, in turn, creates profit for the investor.
- Neutral gearing refers to when net income and loan interest payments break even.
- Negative gearing is when expenses and interest payments exceed the income from the purchased investment(s), resulting in loss of income
Investors should not confuse gearing strategies with margin loans. While both involve borrowing money to invest in assets, the borrower retains ownership of the geared asset, whereas margin loans require using the purchased asset as security.
Why do investors negatively gear investments?
Deliberately designing investments to result in income loss may sound strange—but why do investors apply this strategy, especially in rental properties?
This is because the Australian Taxation Office (ATO) allows individuals to offset tax payables using the income loss from investments, whether in part or the full amount.
Applying the net rental property loss to a person’s tax return can lower tax obligations for the financial year. Any excess loss may still be applied to the next income year. The tax benefits of negative gearing alone make it a worthwhile strategy to some investors.
Negative gearing in real estate
The strategy is often used in rental properties because most investors take out loans to purchase properties.
Rental income and expenses are important in negatively geared investments. Consider Bill who takes out a $350,000 loan with a six per cent annual interest rate to buy a tiny apartment near the edge of the business district. This gives Bill a $21,000 interest payment obligation yearly.
Bill settles for a $280 weekly rent because the size and location of his property make it difficult to entice tenants. This gives him a $14,560 annual rental income, which has a $6,440 income loss.
According to ATO rules, Bill is allowed an offset on tax payables using the stated income loss. This loss could bring his tax payable to nil. If there is still excess income loss, it may be used in the next income year.
But is there a bright side to Bill’s losing investment? It depends.
Bill would have to rely on unrealised capital growth when the value of his real property increases. If the real estate market conditions increase the property’s value to $400,000 at the end of the income year, then Bill would have made a $50,000 unrealised gain.
Negatively geared equities and securities portfolio
Investment portfolios composed of shares, bonds and funds may also be negatively geared if income from dividend, coupon and distribution payments falls short of the interest payments for the loan.
Investors may do this by purchasing shares or funds that have decreased in value, whether as a result of market volatility or revaluation after dividend or distribution payments, or bonds with lower coupon rates.
Changes to ATO rules as of 2017
ATO allowed individuals to claim tax offsets for expenses incurred from owning a negatively geared property. However, the tax office believes that its generous system has been used to dodge taxes.
As of July 2017, the ATO enforced tighter restrictions against claims on depreciation deductions that apply to plant and equipment items in residential and rental real estate. The tax office has also disallowed offsets for travel expenses incurred for any transaction relating to the property, such as rent collection and inspection.
This means negatively geared real property investors may have to offset their income loss with a smaller amount, resulting in a higher tax payable.
ATO may continue to impose tighter restrictions to crack down on people who use negative gearing as a way to dodge taxes.
It’s best for investors to consider their personal circumstances and discuss plans for negatively geared investments with a financial expert before taking out a loan.
This information has been sourced from the Australian Taxation Office and ASIC's Moneysmart.