Negative or Positive Gearing

What is negative gearing?
Gearing basically means borrowing to invest, it is the deliberate use of borrowed funds to acquire an asset where the income is not enough to cover the holding costs and interest, thus creating an annual deficit. This is done with the expectation that the capital appreciation of the asset is greater than the said deficit, thus creating wealth.
 

So, an investment property that's negatively geared is purchased with a loan and the annual interest, property holding costs are greater than the rental income received. To put it in simple terms: cash in is less than the cash going out and the property is making a loss in cash terms, but the property’s capital gains should be larger than the cash loss you’re making each year.

 
If you were living and working in Australia, this negative gearing helps to reduce the income tax you pay on your income (including your salary) as you are allowed to offset the annual deficit against your total income – it is one of the most cost effective tax planning methods available. This is especially true if you consider that nowadays you only pay tax over half the capital gains if you hold the assets longer than 12 months.
 
Now if you’re an expat or a prospective migrant you won’t have any income in Australia and thus have nothing to offset the annual deficit against, but under Australian tax legislation you are allowed to let these annual deficits accumulate year after year and then use them at some time in the future. We will refer to this accumulated amount as tax credits and the great thing is you can accumulate these indefinitely and they do not ‘expire’.
 
So if you return to Australia in some time in the future you can use your tax credits to offset a rental surplus, capital gains on sale or to offset Australian taxable income (salary or retirement incomes). Don’t underestimate the value of these tax credits especially if you consider that the top marginal tax rate in Australia is 48.5%.
 
Because negative gearing deductions offset your income, they are most beneficial to high-income earners. What this means is the more you borrow, the more interest you pay and the bigger your deduction. While everyone wants a large tax deduction, you shouldn't overcommit yourself in order to get one. You still have to make the mortgage payments and those lucrative tax benefits don't arrive until the end of the financial year. In periods of low inflation, the benefits of negative gearing are usually negligible.

 
Is it good to gear?

It may have been first introduced in the 1930s but it wasn't until property prices soared 40 years later that Australian investors jumped on the negative gearing bandwagon. Then, the cashed-up 1980s saw negative gearing take off with a vengeance and it has continued to gain popularity with investors since.
 
Today, rising inner-city residential values have ensured strong capital growth in select areas, allowing investors to embrace another cycle of negative gearing and, depending on capital appreciation, leverage their investments to purchase other residences. With a depressed stock market, inner-city cafes are now thronged with latte-drinkers swapping negative gearing advice instead of tech-stock tips.
 
Newspaper advertisements promoting speedy get-rich-quick property schemes based on negative gearing play on the concept of the "taxman" paying for your investment property. It is, of course, not quite so simple.
 
Negative gearing allows owner of an investment property to write off their costs against their tax.
 
This includes interest on their loan. The interest payment tax write-off makes interest-only loans attractive to investors in the highest tax brackets.
 
Chartered accountant Digby Looker, of Hall Chadwick, explains: "If an investment property costs $100,000, the purchaser puts in $10,000 of their own cash and borrows $90,000. If the property rises in value 5 per cent in a year, then the investor has made $5000 on the $10,000 investment - a gain of 50 per cent."
 
Investors have to take into account buying and running costs, he says, but they can write these off against tax. If the property's running costs are $10,000 a year and an investor is in the highest tax bracket of 48.5 cents in the dollar, then for every dollar spent he or she can claim back 48.5 cents from their tax bill, Mr Looker says.
 
"In effect, on $10,000 they only pay $5150 and this where the term `the taxman pays for the investment' comes in, as the remaining $4850 is written off."
 
Mr Looker says an investor must have the financial wherewithal in reserve to meet any potential repayment shortfall and ongoing costs. This is why negative gearing best suits people who have reliable cash flows and surplus income, he says.
 
He also suggests that another advantage of an interest-only loan is that it allows an investor to redirect cash to debt repayments, clearing credit card accounts, for instance, or the primary home loan, on which tax benefits cannot be claimed.
 
"If an investor reduces a $100,000 home loan, which accrues 7 per cent interest, by $10,000 then that effectively saves the investor $700 in interest repayments," he explains.
 
While negative gearing has been viewed as a tax write-off for the rich, tax incentives for investment are nothing new.
 
In 1985 then federal Treasurer Paul Keating quickly discovered the importance of negative gearing when he altered the investor's capacity to write off interest payments against tax. Investment in property dropped dramatically, say property analysts, forcing up the cost of rents and house prices, and in 1987 the tax write-off was reintroduced.
 
The negative gearing strategy is a double-edged sword. The lure of negative gearing is that it offers buyers the chance to purchase ever more expensive properties and reap greater returns on their investments.
 
But on the downside, it magnifies a loss equally. This is why property and investment analysts warn investors that negative gearing should only be seen as icing on the cake.
 
Consulting actuary Nick Renton says negative gearing should not be seen as an investment end in itself nor a device for turning a bad investment into a good one.
 
Investors should be prepared for the worst-case-scenario, he cautions, of becoming unemployed and unable to make repayments or not being able to rent the property for lengthy periods, or at all.
 
Unlike shares, he adds, property investments cannot be turned relatively quickly or cheaply back into cash. While a fire sale of a property can take as little as a month, the buying and selling process generally takes at least three to five months and is particularly costly, with marketing fees and agents' commissions.
 
Property asset management specialist Victor Altomare, of Harvard Securities, says negative gearing is a mechanism for holding an asset until it gains in capital value.
 
But he says the suitability of negative gearing as an investment is a vexed issue.
 
Banks, he says, look at a loan in terms of the borrower's ability to service that loan, a financial planner will examine alternative investment strategies and returns to spread the risk, plus the client's financial profile, while a real estate agent usually favors the long-term capital gain perspective over other approaches.
 
"From an estate agent's perspective, geared property is a seven to 10-year proposition, or one traditional property cycle," Mr Altomare says.
 
This long-term perspective is what negative gearing is all about - making good the losses of today with the profits of tomorrow, he says.
 
For most investors, capital appreciation is the key objective of a property purchase and with an increasingly broad section of the community tuning in to the need to provide for retirement, negative gearing has become synonymous with property investment.