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Negative Gearing Explained: Understanding Investment Losses & Tax Benefits

Negative gearing occurs when an investment that is made using borrowed funds produces cash flows that are lower than the interest and other expensesExpensesAn expense is a type of expenditure that flows through the income statement and is deducted from revenue to arrive at net income. Due to the paid towards that investment.

Summary

Negative gearing occurs when an investment that is made using borrowed funds produces cash flows that are lower than the interest and other expenses paid towards that investment.
A benefit of negative gearing is that any value of net loss can be offset against any other income that will be taxable.
Negative gearing is mostly beneficial for individuals who are earning high income and are in a larger tax bracket, which will allow them to reap the tax benefit.

Understanding Negative Gearing

The concept can be explained using the figure below:

Negative Gearing Explained: Understanding Investment Losses & Tax Benefits

Normally, negative gearing is seen in the real estate marketReal EstateReal estate is real property that consists of land and improvements, which include buildings, fixtures, roads, structures, and utility systems. Property rights give a title of ownership to the land, improvements, and natural resources such as minerals, plants, animals, water, etc. where properties are rented. For a person who bought the property and leased it out to a tenant, the biggest expense he faces is the interest on the loan to buy the property.

Other expenses are also incurred, which can be in the form of maintenance fees, repairs, and property taxes. The cash flow from the property is the rental income received from the tenant.

Positive Gearing

The term gearing is often used when money is borrowed to invest in an asset, typically an investment property. The income that yields from the investment can be either positively or negatively geared.

Positive gearing is when the return you get from the investment (rental income) is greater than the interest paid on the borrowed amount and other expenses related to the property.

Normally, the income derived from positive gearing can be used to meet future repayments or investment purposes.

Tax Implications of Negative Gearing

Negative gearing can be triggered by several factors. One possibility is if you are in a high-interest-rate environment and rental payments are not sufficient to cover your expenses.

Another situation can be when the loss is magnified by the depreciationDepreciation MethodsThe most common types of depreciation methods include straight-line, double declining balance, units of production, and sum of years digits. of the property or any capital expenditure related to the property. Since both are tax-deductible, it can result in negative gearing as well.

A benefit of negative gearing is that any value of net loss can be offset against any other income that will be taxable. For example, if the income you earn is taxed at a rate of 30%, each dollar contributing towards negative gearing loss will help you save $0.30.

There are also certain downsides to negative gearing. The tax benefits are normally advantageous for individuals who earn a high income. If someone is earning and paying little or no tax, having negative gearing on your investment property will not make a big difference.

Negative gearing can also inflate the value of the property if expenses are not controlled in an orderly fashion – rental payments may be increased, leading them to be higher than the market rental yield.

Negative Gearing Example

Suppose a person named Bob buys a property for investment purposes by taking a loan from the bank. He rents that property to his friend and receives a rental income of $10,000 per annum.

Bob pays interest on the bank loan and bears the expenses related to the investment property. The total annual amount of interest and expenses is $25,000. In this case, it is evident that because the inflows are less than outflows, we see a case of negative gearing of an amount equal to $15,000.

Negative Gearing Explained: Understanding Investment Losses & Tax Benefits

Now suppose that the year has passed, and Bob’s annual income is $150,000 from his full-time job. As he has faced a loss of $15,000, the amount will be reduced, and his total taxable incomeTaxable IncomeTaxable income refers to any individual's or business’ compensation that is used to determine tax liability. The total income amount or gross income is used as the basis to calculate how much the individual or organization owes the government for the specific tax period. will now be $135,000.

Bob is essentially saving the tax incurred equivalent to the loss amount on his annual earnings.

Risks Associated with Negative Gearing

1. Lack of cash flow for repayments

Negative gearing can lead to a high risk for the investor. The biggest risk is when he borrows money for buying the investment property. It is possible that the investor may not have enough cash flows to make the interest and principal payments on the loan.

2. Lack of tenants (and loss of rental payments)

The risk can also arise if the investor is unable to find a tenant and the property is unoccupied for a long time, leading to a loss of rental payments.

3. Significant property depreciation

Another risk can arise in the form of significant value depreciation of the property or any changes in tax laws that may be unfavorable for the investor.

All the things above must be accounted for when deciding to invest in a property to avoid a negative gearing situation.