When you borrow money by taking out a home loan to buy an investment property, that property is considered ‘geared’. Property investors often talk about gearing, because it’s a way of comparing the income and financial outgoings of an investment property. In this article we’re going to look at different gearing positions and the impact they can have.
Positive gearing. A property is positively geared when the rent covers the interest repayments, plus other regular expenses. Another term for a property like this is, ‘cashflow positive’.
Negative gearing. A negatively geared property earns less in rent than it costs to own. The rent is not enough to cover the interest repayments and other regular outgoings. There’s a shortfall between the income and the cost of ownership. This results in a financial loss for the owner of the property. This is also known as ‘cashflow negative’.
Neutral gearing. If an investment property earns enough rent to cover its costs, but not much more, it’s considered neutrally geared, or ‘cashflow neutral’.
If you own an investment property that’s positively geared, this could be a source of income for you.
You’re making money from owning the property. If your investment property is negatively geared, you’ll need to pay more money to keep covering the costs of owning the property. The larger the shortfall – the more negatively geared the property – the more money you’ll need to make the loan repayments and other costs associated with owning the property. The extra money might come from your salary or wages.
Before you buy an investment property, it’s important to know the total likely costs of owning it, so you can make an informed decision.
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For a positively geared investment property, the extra income you make after the costs are covered may be subject to income tax.
With a negatively geared investment property, it may be possible to offset losses against other income. For example, an investor might make a loss on an investment property over the financial year and then use that loss to reduce the tax payable on other income they earn.
You may be able to claim tax deductions for some of the expenses associated with owning an investment property. This might include loan interest, property management fees, council rates, depreciation, insurance, and maintenance. Talk to your accountant or tax adviser about whether your tax payable can be reduced.
For an investment property, if you sell it for a profit, you’ll pay tax (also known as capital gains tax) on that profit. How much capital gains tax you pay will depend on several factors, including how long you’ve owned the property and what individual marginal tax rate applies in your situation.
If you own an investment property for more than 12 months, you may be able to get a capital gains tax concession – talk to your tax adviser for professional advice about your situation.
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Investment properties could be a way to make extra income, so why do investors choose to invest in properties that don’t make enough to cover their costs?
Negative gearing is typically used as a long-term investment strategy. Investors choose to own negatively geared investment properties because they believe the value of the property, also known as capital growth, over time, will outweigh the shorter-term negative cashflow.
Even though the investor needs to top up the money each month to cover the property’s costs, they may anticipate that the value of the property will increase over time, which outweighs the additional costs associated with it.
This strategy is often used by individuals who have the ability to comfortably cover extra costs and market ups and downs.
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Negative gearing could be a successful long-term strategy because the situation can change over time in favour of the investor.
Over a longer period, the rent on a property typically increases alongside inflation, which means the income it’s generating goes up. Provided the loan amount stays the same or gets smaller, eventually a property that's negatively geared can become cashflow neutral, as the income covers the costs of ownership.
Then, as the income keeps increasing and the loan repayments remain reasonably steady, the income may begin to be higher than the outgoings, and the property becomes positively geared. After many years or decades, the negative cashflow property may become a positive cashflow property. It can then provide extra income, for example in retirement, or be sold (hopefully for a gain).
In the meantime, by offsetting their losses against their income to reduce their tax obligations, investors can reduce the financial impact of the losses.
Sometimes, experienced investors use strategies that can turn negative cashflow properties into positive ones. For example, they might renovate a house, reorganise the layout to add a room, or add a granny flat.
These types of strategies can lead to more rental income from the property, which may help offset the potentially high cost of undertaking the changes. If successfully achieved, the property could become cashflow positive.
Gearing adds risk to any investment because there’s a debt associated with the property and the owner needs to ensure they can cover the costs, for example, in the event a property is vacant, or that there are rate rises, or repairs needed.
Positively geared investment properties provide additional income for the owner over and above the costs associated with owning the investment property. This makes them less risky from a cashflow perspective than negatively geared investment properties. However, there are still risks to consider, which apply to any rental. These might include the property not being able to attract tenants (so no rent is received), or unexpected maintenance costs, such as a roof replacement.
A negatively geared investment property has an additional cashflow risk. An investor with a negatively geared property must regularly cover the shortfall between the rent and the costs. This has a negative impact on everyday cashflow. Unexpected events can then put extra pressure on expenses.
For example, if an investor lost their job, their investment property gearing could make a big difference to their financial situation. Owning a positively geared rental could give them extra income that helps to support their living expenses.
Owning a negatively geared property could prove more challenging, and potentially put them under financial stress. They might have to sell the property to stem their outgoings. If this comes at a time when property values have fallen, the sale could potentially result in losses, which could set that investor back in achieving their financial goals.
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If you’re considering buying an investment property, it’s important to consider all the risks before you make a purchase. This includes the likely cashflow and the rules around owning an investment property.
Negative and positive gearing strategies each have their advantages and disadvantages. The right strategy for you will depend on your individual situation, so it may help to speak to a tax adviser, accountant or financial advisor. It may be useful to talk through your long-term and short-term financial goals, and how much disposable income you have.
The tax implications may also play a part in your decision-making, both in terms of your ongoing taxable income and potential capital gains tax to pay after a sale. Tax rules can change often, and their impact will depend on your situation, so we recommend you always seek tailored advice from a professional.
Your tax adviser can calculate the net tax outcomes of a potential gearing strategy for your circumstances, or for general tax information, the Australian Tax Office has a section dedicated to residential rental property.
If you’re considering a loan to buy, build or renovate an investment property, we could help guide you through the journey. Our calculators estimate how much equity you may have in your home, how much you might be able to borrow, and what your repayments might be.
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This information is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information and if necessary, seek appropriate professional advice. This includes any tax consequences arising from any promotions for investors and customers should seek independent, professional tax advice on any taxation matters before making a decision based on this information.
Taxation considerations in this publication should not be interpreted or used as tax advice or a tax guide.