How negative gearing works
Gearing refers to the act of borrowing money to purchase investments. The resulting investment may be positioned to earn profit, break even or incur loss, otherwise known as positive, neutral or negative gearing.
In terms of negatively geared investment properties, investors accept loss in exchange for a reduction in their tax payable in hopes that the property’s value will appreciate and they can make up for the loss once it is sold.
Negative gearing example
Consider Bob whose annual income is $95,000 and pays at a marginal tax rate of 37 per cent, amounting to $22,782 total tax payable—plus $1,900 Medicare levy. This gives Bob an annual net income of $70,318 or a $5,859.85 net monthly income.
Bob decides to purchase a negatively geared property for $500,000 by borrowing the full amount from the bank at five per cent interest or $25,000 per year. He also estimates a $3,000 annual operational expense. Let’s assume that Bob paid the stamp duty using his personal savings.
If Bob receives an annual rent income of $18,000, this means he is $7,000 short for the interest payments and $10,000 if the operational expenses are added. He would have to use $10,000 of his own income to ensure that payments are met for the investment property.
To offset this loss, the government allows the income loss from the property to be offset against Bob’s taxable income. This brings down his annual taxable income to $85,000 and his tax payable to $19,172 plus $1,700 Medicare levy.
Bob’s situation shows that he loses $6,190 in the negatively geared property when the $3,810 savings in tax (inclusive of Medicare levy) is taken from the $10,000 loss. His only way to break even or make a profit from the losing investment is if the property’s value increases over time—but it has to be more than enough to cover all the losses and the capital gains tax (CGT) Bob must pay when he sells the property.
History of negative gearing in Australia: policies and changes
Australians have used the negative gearing strategy for a long time but it wasn’t until 1983 that the government focused on establishing tighter restrictions on the strategy.
The Hawke government changed these regulations in 1985 and allowed income loss from negatively geared properties to be offset against other income—only to be overturned six months later, in July. It also introduced the CGT two months later.
After two years of lobbying, the government once again allowed property investors to offset income loss against labour income in 1987.
There have been prior proposals to reform negative gearing rules and limit its application to new structures, such as the Labour Party’s proposition in 2017. While the proposition was not passed, the government imposed tighter restrictions on depreciation claims and offset on travel expenses in relation to the property has been disallowed.
Which is better: negative or positive gearing?
Financial advisers and experienced investors agree that while negative gearing has its merits, the benefits owners receive decrease after the first year. The negatively geared property must ultimately yield higher returns than the accumulated losses when it is sold.
Experts still would not rule out negative gearing as a valid investment strategy, but they caution against simply looking at the tax deductions—especially if the intended asset for purchase is real property.
For those who simply want to get into property investment scene, experts recommend finding a positively or neutrally geared property instead.
This information has been sourced from the Australian Taxation Office, ASIC’s Moneysmart and Smart Property Investment.