Negative gearing describes the situation where the costs associated with a leveraged investment are higher than the income from it. In other words, when the project runs at a loss.
Negative gearing is a popular strategy in investment property. The word ‘leverage’ is used to describe the process whereby an investor borrows a significant percentage of the total cost of the property so as to have the funds needed for the transaction. The investment can then be described as being ‘geared’. In other words, the investor’s (small) deposit is added to the bank’s (large) mortgage loan. This enables this ‘geared’ investment to achieve far greater returns for the investor.
Mortgage costs are the highest costs a geared investor must face. When maintenance and property management costs are added to the mortgage costs, the income – in the form of rent from the tenants – can often be lower than the total costs, particularly in the early years of the project. This is then described as a project that is ‘negatively geared’.
Investors are prepared to ‘lose’ money in this way for two reasons:
- The geared investment property is able to generate capital growth that history has shown has averaged at 8 per cent per annum. In other words, the capital growth is very attractive, and more than offsets the monthly income shortfall*.
- The annual interest paid is fully tax deductible – along with maintenance and some other costs**. Any shortfall in income relative to the costs can be offset against income from other sources, such as the wage and salary income of the investor.
*Assumes a well-planned and well-structured investment, in a growth location, and assumes the investor has the monthly cash flow needed to cover the shortfall.
** A full list of tax-deductible costs can be obtained from McCarthy Group.
The government has structured these tax deductions to encourage private investments into the property market, which relieves it of the need to provide large-scale social housing.
It’s a concept that works well for renters, for the government and of course, for investors. It enables investors to buy and hold a property they would otherwise be unable to afford, knowing that in time, the capital returns will make the short-term negative gearing losses insignificant.
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