Negative Gearing - Discover the Fact and Fiction

Does Negative Gearing Mean you Lose?
Not too many people buy a property investment with their own money. The advantage of borrowing, or gearing, to invest is it allows you to go into investments that ordinarily would be closed to many.

The basic attraction of negative gearing is its immediate tax advantages while offering the potential of long term capital gains.

Clear the Air for Some
But, before we go too far down that road we should address the concern that might be formulating in the minds of some, who may be thinking, "Why would I want to continually put money in, on an ongoing basis to prop up an investment?" …." Sounds like a loser to me!"

Negative gearing allows an investor to control a sizeable investment with minimum, or no upfront monetary outlay depending on whether or not the investor already has existing equity in property which they can use as security.

It's called negative gearing, because in the beginning, your investment carry's a loss from week to week, or month to month.

Important Negative Gearing Keys
Then, hopefully as time goes by your investment increases in capital value and the rent returns will increase to the point that eventually the investor no longer has to make contributions in order to support the investment.

A profit key to the negative gearing of an investment in property is to initially purchase a property situated in a great location that will deliver strong ongoing rental demand and potentially provide excellent capital growth. Then, to further enhance your investment develop a property investment strategy that will keep any necessary ongoing contributions (holding costs) to a minimum.

That's a simplistic explanation, but in order to minimize your investment risk it's important you have a detailed understanding of negative gearing as there are a few 'investing pitfalls' that are glibly avoided being discussed when you read the glossy brochures or when you are talking to promoters of property developments.

Managing Risk Factors
The important risk factors that any would be negative gearing investor needs to look at is once they've located a potential property they would like to purchase, then they should have the discipline to take a step back and look at it in a holistic context.

Meaning, if you're buying the property today and the prevailing market conditions dictate you have access to low home loan interest rates, the property is showing good rental returns and the outlook for capital growth of the property looks good. And after doing your property investment analysis it shows your holding costs for this potential property are low, possibly non-existent, or it could even be returning you a positive cash flow.

Surviving Changing Economic Conditions
So, it all looks good and now you're getting excited. But, just a minute, hold on there partner! What happens if interest rates go up? What happens if the property market goes from hot to cold? Have you factored these possibilities into your medium to long term strategy?

When using property and negative gearing it's important to develop a strategy that will endure over the medium to long term. That it will take into consideration the financial peaks and valleys of changing economic times that can be encountered along the way.

So, it's critically important when investing in property through negative gearing that you match the property to your financial profile with an emphasis of how affordable the property will be for you in the event financial conditions change and become not so user friendly as they were when you first purchased the property.

The benefit to this strategy over the medium to long term will be to end up having an investment property that emerges as a sound investment, providing you with ongoing increasing rental income and continuing capital growth.

The rule of thumb is:

• Well researched negatively geared property will provide strong capital growth, increasing rental yields and eventually allow you to leverage your investment into becoming a positively geared property.

However, it's important to avoid over heated property markets that are producing low rental yields and inflated prices. Because, when the market deflates your investment is going to get the wobbles, especially if the rental amount (rental yield) also reduces in a poor market as this can increase the amount you have to subsidise your investment by during the poor performance period.

Definition of Negative Gearing

Doing the Sums on the Income and Expenses
Rental properties are considered negatively geared when the annual gross rental income is less than the annual running expenses. The recognized expenses to include in the running expense category include property management fees, rates, water, maintenance, insurances and if applicable strata fees) as well as any interest being paid annually on an investment property loan.

So, the bottom line result is a net rental loss arises. In most cases, you're allowed to offset the net rental loss against your other income, such as your personal taxable income when you do your tax return at the end of the financial year.

The idea is, these losses will reduce your taxable income for the year and you may even end up being entitled to a tax refund (tax credit), on any income tax that has been paid on your behalf during the relevant tax year.

Our investment property calculator (to be constructed, coming soon) can be used to show you in more detail how negative gearing and positive gearing (to be constructed, coming soon) works.

Let the ATO Help You
Also, if these deductions make a significant reduction to the amount of tax you would normally have to pay, you are entitled to lodge what is known as a tax variation form with the Australian Tax Office enabling you to reduce the amount of tax normally paid at each pay period.

In other words if you are accumulating a sizeable end of the year tax refund, because of negative gearing, or even positive gearing from investing in property, then you can lodge the tax variation form and have the pro rata amount of tax credited back to your regular pay check.

Increase Your Cash Flow
For example, if you've generated tax credits of say $7,000 for the year (which is not an untoward amount when investing in new property) from investing in property. Now, assuming you pay that much tax in a year and you're paid on a weekly basis, then you can apply to have $140.00 per week put back into your pay.

Many property investors use this property investment strategy to increase their cash flow. Any tax professional can assist you with this form.

If you leave the whole of the tax refund with the Tax Office until the end of the year they're not going to pay you any interest on the money. So, if it's legally allowable you might as well get the money incrementally paid back to you during the year.

Tips on Borrowing to Invest
Negative gearing entails borrowing money when investing in property, so it's important to ensure the investment is sound, as un-researched, unsound investing in property can cause a set back to your future financial plans.

However, plenty of people borrow to invest every day in shares, managed funds, buying an investment property etc.

Many who have existing equity in residential property don't have to use their own cash and in most cases can borrow enough money to cover not only the purchase price, but also all of the associated investment property costs. This way they avoid taking any money out of their pocket.

For those who don't have existing equity there are numerous lenders who will loan you up to 95% of the property's value for negative gearing (conditions apply). This enables individuals to invest in property using a 5% deposit plus the purchase costs.

When Borrowing can be a Benefit
The major benefit of borrowing to invest is, it opens up investment opportunities today that may not be available to you otherwise, because time passes us all by. Additionally, it creates the dynamic of gearing or leverage of using other people's money.

It's important that you borrow sensibly, because while leveraging can increase your returns exponentially it can also come back to haunt you by magnifying the losses of a bad investment.

Are They Really Apples?
Some property promoters will tell you that negative gearing is simply defined as a property investment where the mortgage interest exceeds the rental income. But, in the meantime ignore all of the other necessary running expenses. However, we suggest this should be debated, because when it's defined this way it opens the door for anyone to extol the benefits of any property investment to be called positively geared.

In contrast to negative gearing, a positively geared property investment is defined as a property, that after all running expenses have been paid, there is still money left over. In other words, it's a "positively cash flowed' investment. We suggest you may want to use the same definitions when analyzing your potential property investment strategy, so you can be reassured you're not deluding yourself.

Learn to Judge for Yourself
Okay let's use an example for demonstration purposes. We'll say Bob has an annual gross taxable income of $85,000 and he's looking to invest in property, let's say for a purchase price of $350,000.

For this example we're going compare the difference between new and older investment properties.

Also, keep in mind for the sake of this scenario it doesn't matter at this juncture, whether it's a house or a unit.

We're also going to assume for the exercise Bob will borrow enough to cover the purchase price and the associated purchase costs.

New vs Old Can Make the Difference!

First let's examine an older investment property where you wouldn't have the benefit of any depreciation losses, which if you did, it would help the cash flow by reducing your taxable income by providing extra tax deductions in addition to the deductions of rental expenses and mortgage interest paid. Therefore, it would increase your cash flow by reducing your payable income tax.

Our example assumes typical rental property expenses and we're going to assume interest rates have gone back up to a more realistic 6.5% (which they eventually will).

Our examples will assume the only difference between the two properties will be the depreciation, but in reality you would get lower rent for the older property and it's possible your expenses would be higher, because of required maintenance. So, it's highly probable in the real world the results for the older property wouldn't be as good as shown.

Additionally, this example is based on negative gearing, i.e. the investor financing the full purchase price as well as the purchase costs.

Older Property without Depreciation

So, if you were to subtract the Tax refund ($3,868) from the 1st years income shortfall ($10,238) it would mean Bob would have to subsidise this property (i.e. negative gearing) in the first year with an additional contribution of his own of $6,716, or $129.00 a week.

The Other Side of the Coin is Shinier
The other side of the coin of course is to look at what happens if you buy a new property for the same amount of money. You could probably buy a new property in the same location as the older one we were discussing.

Albeit, it may be a 1 bedroom apartment as opposed to a 2 bedroom older one, however don't let that put you off, as single person households are the fastest growing household category in the property market.

Also, keep in mind the property is only a vehicle taking you to the end goal which is your wealth creation. A good point to remember is to always invest with your head controlling your heart.

Okay, enough of the sermon, what happens if it's a new property for the same amount of money?

New Property with Depreciation

Now, if you were to subtract the Tax refund ($6,716) from the 1st years income shortfall ($10,238) it would mean Bob would have to subsidise this property (i.e. negative gearing) in the first year with an additional contribution of his own of only $3,522, or $68.00 a week.

Much Easier Road to Making Money
With new property you will not only receive substantially more in tax deductions, but there are numerous other positives as well. For example, your ongoing maintenance will be lower, you will attract higher rents, you may attract a better profile of tenant and your chances of better capital growth are enhanced.

The new property, based on the above factors would have weekly holding costs of $68.00 a week. This is substantially more affordable than the older property scenario and overall a more attractive property investment strategy.

As a point of interest though, at today's current low home loan interest rates (5.14%), or even lower, the weekly holding costs for the new investment property described above would only be $10.00 a week.

Home Work Pays Dividends
However, keep in mind, with the reduced tax brackets most people find themselves in today, positively geared properties are not so easily found as negative gearing ones. So, any claims for a positively geared investment property should be carefully examined.

This would not only be for the correctness of the mathematical calculations being used to support the positive cash flow claims, but also for the ongoing potential of the investment in the way of capital growth and rent increases. Because, frequently many of these older cheaper properties are going to be in lower socio economic areas where capital growth and rental increases may not be obtained so readily.

We see many positively cash flowed properties promoted, but when scrutinised more closely, they're older cheaper properties with little or no depreciation benefits available. And they're frequently located in depressed, or country areas where capital growth potential is less likely.

Maintenance and repairs of older properties should also be factored into any property investment strategy when calculating your running costs.

Negative Gearing Requires a Successful Investment
In order to develop a property investment strategy that's going to increase your chances of successfully negatively gearing a property investment will require the incorporation of some important fundamentals into your plan.

But, before we go any further we should make it clear that our definition of successfully negatively gearing a property investment means you will be substantially better off further down the road even though you had to subsidise the investment to get it started.

What About Renovating a Property?
If you have the required skills to find a fixer-upper at a bargain price and you're able to skillfully manage your renovation costs in order to be substantially ahead cost wise at the completion of your project, then we would encourage you in endeavours of this nature.

However, if you don't have the required skills and experience, you should be very aware the renovation game has a lot of traps for unwary players. The best time to get into the renovation game is at the beginning of a strong capital growth market as this will help cover any cost overruns that occur. And be assured this can be more often the case than not, with renovations.

You should also keep in mind that more often than not, completion times for renovation projects run over the estimated completion date. And during this time, you're not receiving rent and your expense clock continues to tick with such things as mortgage interest. So, consider carefully this form of property investment strategy, because until the property is habitable you will only have cash outflow. This then amplifies your negative gearing.

We have seen some nightmares created with this type of investment in the way of would be investors estimating that it would take 3 months to get the property into shape ready for a tenant, or resale. Nine months later or even longer in some instances they're still struggling to get the place finished and cost overruns are spiraling higher and higher. What a disaster!

Where the Profit is
A little earlier we compared the difference of investing in new and older properties with negative gearing. It was shown that with higher home loan interest rates (6.5%) the new investment property would need to be subsidized by $68.00 a week for someone with a gross taxable income of $85,000 per annum.

Now, most people are not prepared to fork out $68.00 per week forever, just to feed a loss-making investment, so there has to be other expectations in the way of turning around the small yearly loss into a profit as soon as possible.

A little Pain will Show Good Gains
As mentioned earlier his can be achieved by investing in property that adheres to the fundamentals of successful property investing and that will provide increasing rental returns and ongoing strong capital growth.

So, in real time, a correctly selected property will start reducing your holding costs, because of the increasing rents. Also, a property providing good capital growth will start to show a paper profit, in a reasonable period of time.

An important fundamental when investing in property is to compare the profit potential and the running costs between new and pre-owned properties. When you do a comparison as we did earlier, it's surprising to many, when they find that buying new properties is not only potentially more profitable, but when negatively geared the ongoing running costs are substantially cheaper.

Profits can be significant
If we project into the future for a moment and use the same new investment property scenario as we did earlier. That is, the property is purchased for $350,000 and rented for $365.00 per week. But, for this equation we'll assume that rental increases will stay in line with a rate of inflation of 3% and modest capital growth rate of 5% per year.

So, basing the equation on those projections, then after 10 years it would result in the property being valued at $570,113 and if the rental income kept in line with the inflation rate it would have increased to $445 per week (which wouldn't be a lot to ask for over a ten year period in a high demand low vacancy area).

The above example equates into an internal rate of return (after tax) of 29.01% and a pre tax return of 47.95%.

A question worth asking is, where else could you invest $89.00 a week and accumulate a gross profit of $230,000 over 10 years?

Managing the Down Side Risk
So, as just illustrated, the negative gearing of property can be a highly profitable secure venture. But, you should consider it as a medium to long term investment proposition. Also, it's not necessarily expensive, but you should feel comfortable initially with the affordability of it, not only immediately, but also comfortable that you will have an ongoing reliable income to allow you to support your investment.

Other affordability issues that should be taken into consideration are maintaining a reserve fund in the event home loan interest rates increase (even though some of that will be tax deductible) and possible rental vacancies where you won't be receiving rent, which by the way will reduce your taxable income and in turn increase your tax refund.

In Summary
Important fundamentals that should be incorporated into your negative gearing property investment strategy in order to help your success would be to;

• Buy good quality investment properties with ongoing increasing rental yields in capital growth areas.
• Buy new investment properties in affordable areas so you're comfortable with the initial amount of debt you have incurred and also, you can deal with interest rate increases and short term rental vacancies.
• New investment properties with good depreciation schedules can provide a hedge against increasing home loan interest rates, and per chance you go through a period of reduced rental income.
• Also be confident you will continue to earn reliable income from employment or other sources so you can cover borrowing costs and any unforeseen circumstances.
• This is most important in the early years. Because, after a few years if you stumble financially, but in the meantime you've received reasonable capital and rental growth, then the property may be self supporting by that time.
• And in a worse case scenario you may be able to bail out without loss or maybe even a profit by selling the property.

Warning
If this is your first time buying an investment property and you happen to borrow beyond your affordable means, you can run the risk of incurring financial damage that may prove to be difficult to fix. Be practical, do some hard yards and develop a negative gearing property investing strategy that you know is affordable for you.

A Timely Tip
Smart money management say's, you should use each investment in property as a stepping stone. Meaning, if you keep your debt well within your affordability range it shouldn't stress your cash flow or you.

By always focusing on a property investment strategy that's creating equity either through capital growth or fast mortgage reduction you are continually strengthening your financial position and it will position you to reach your financial goals faster and more securely.

More information:

Value Investing In Property
Positive Gearing Advice
Best Property Investment Strategy
Investment Property Solutions
Investment Property Management
Investment Property Insurance

Return from Negative Gearing - Discover the Fact and Fiction to Property Investing facts
Return from Negative Gearing - Discover the Fact and Fiction to Discover Financial Freedom

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