Negative gearing - smart strategy or risky business?

Property is always a hot topic of conversation whether it’s on the news media or at backyard barbeques, everyone seems to be talking property prices.  Fuelling the conversation is the news that property prices in Melbourne and Sydney reached new peaks last September. The median house price in Sydney is now well over one million at $1,068,303 and in Melbourne it's now grown to $773,669[1].

The high prices are the result of a combination of factors — the shift from high to low interest rates over the last 20-30 years, which has boosted borrowing and buying power, and the lack of supply.  Many people also point to the impact of negative gearing and the advantages it offers investors over first home buyers when it comes to the property market.

While negative gearing can be a powerful tool for building wealth, that doesn’t mean it’s for every investor or every situation. Here’s how it works, and how to decide if it’s right for you.

How it works

Gearing is simply borrowing to invest. As many home-owners know, it can be a winning strategy because it enables you to buy bigger and more valuable assets with less cash upfront, so you can potentially earn more income and make larger capital gains.

If the income from your investment is higher than your borrowing costs, you’re said to be positively geared. But if you pay more in interest and other costs than you earn from your investment, you’re negatively geared.

In other words, negative gearing means making a loss on your investment today in the hope of making a gain tomorrow. So how can you use it as a strategy to build wealth?

Multiplying your gains

The key is that rental income is just one of the ways you can make money when you invest in property. The other, often much larger, money-spinner is the gain you make when you eventually sell, always assuming the property has risen in value.

That’s because gearing also has the effect of multiplying your capital gains. Here’s a simple example. Let’s say you invest $500,000 in a property and it rises 10% to $550,000, you make a 10% capital gain. But if you invest $100,000 of your own money and borrow the rest, that $50,000 profit is 50% of your initial investment — 10 times the capital gain. For investors, this multiplying effect can often outweigh the short-term losses that negative gearing involves.

But there is also a downside. Just as gearing multiplies your gains when you invest successfully, it also multiplies your losses if an asset falls in value. And remember that house prices can and do fall, especially after a period of strong gains. That’s why gearing should always be used as a long-term strategy, allowing you ride out any short-term ups and downs in the market.

Tax concessions

Of course, the other reason negative gearing is popular with investors is that it can bring sizeable tax concessions. That’s because investors can generally claim a tax deduction for their interest and costs.

For example, if you're in the highest 49% tax bracket (including the Medicare and budget repair levies), and you're paying $20,000 a year in interest and other costs, you could receive a tax concession worth $9,800, making that expensive property look much more affordable. So while you may be making a loss today on your negatively geared investment, you can offset that loss against your other taxable income, lowering your overall tax bill.

But an important word of warning: tax laws are complex, and everyone’s situation is different. So it’s essential to get professional tax advice before you commit. And while the tax concessions can make your strategy more effective, it is never a good idea to let tax influence your investment decisions. After all, a bad investment with tax concessions is still a bad investment.

As you can see, making gearing work is all about getting the numbers right. That’s why it makes sense to talk to a professional who can help you stress-test your strategy and find the most rewarding option with the least risk. To find out more, please contact us.

Source: Capstone and Colonial First State

[1] Domain House Price Report September 2016.