What is negative gearing?
Negative gearing in terms of property is when you borrow money to invest in a house and the income that you make from the rent is less than the interest you are paying on the loan and other expenses, therefore, you are making a loss. However, in the long-term, you might actually make a profit on this investment whilst also being able to use those losses in your taxation.
Let's apply this to a real-life situation with simple numbers. Prepare for a lot of numbers.
Oscar has bought a house for $560,000 and has taken out a loan of $520,000 with an interest rate of 6% so he is paying $31,200 in interest annually. On top of interest, Oscar is also paying $4000 for property expenses. In total Oscar is paying $35,200 per year for interest and expenses. Oscar’s rental property generates $450 per week in rent so that is $23,400 per year. Oscar’s investment property is negatively geared because the rent does not cover his expenses and he is paying $11,800 ($23,400 - $35,200) from his salary to cover the investment.
So why would Oscar make this investment if he is making a loss of $11,800 per year?
It is not ideal to be making a loss but it is hard to buy property that makes you money straight away, the pressure on properties prices are, although alleviated in recent years, not particularly accommodating, therefore buying a negatively geared property makes it easier to invest in property. Another reason Oscar might have made this investment is that he can deduct his losses from his taxable income. In the end, Oscar’s hope is for long-term capital gain.
Oscar’s taxable income in this scenario is:
Rental income: $23,400
Property expenses: $4000
Taxable income: (salary + rental income p.a) - (property expenses + interest) Taxable income: ($70,000 + $23,400) - ($4000 + $35,200) = $93,400 - $39,200 = $54,200
What is a capital gain?
Capital gain in terms of property is the difference between the amount you paid for your property and the amount you make when you sell the property.
If in a year Oscar’s property increases 5% that would mean the value is $588,000 meaning if he sold that property for that amount his capital gain is $28,000 because he originally bought the property for $560,000. To put it simply, (sale price + sale fees) - original price = capital gain.
The reason capital gain is important for a negatively geared property is it can counteract your losses.
Let's say Oscar’s property value increases by 10% in two years of him owning it so the value is $616,000. When you remove the amount he originally paid for the property, $560,000, and the loss he has made over the two years, $23,600, from the current value of the property, $616,000, Oscar has still technically made a gain of $32,400.
What is positive gearing?
In contrast to negative gearing positive gearing means you are making money so the amount you earn from rent is greater than the amount you pay in interest and property expenses.
If Oscar had more money saved and only needed to take a loan out of $400,000 with an interest rate of 6% then he would be paying $24,000 interest and $4000 in property expenses, $28,000 total. And if the rent he's earning was $550, $28,600 p.a then he is not making a loss he is earning $600. This investment is positively geared because of that $600 income.
That is why sometimes rent increases can change a negatively geared property investment into a positively geared investment.
It's worth noting that the numbers above are simplified as you'd normally have other costs other than just the mortgage, these can be purchase costs, stamp duties and conveyancing as well as other ongoing costs such as body corporate fees, insurances, agency fees, rates etc . There are a lot of differing opinions on whether negatively gearing is a good investment strategy or whether is an investment strategy at all so it is important to do your own research and talk to investment or financial advisors before you make any decision to help you better understand how each strategy would affect you.
If you are thinking of going down the path of buying your first investment property and would like to know more of what to expect, Cubbi could help you understand the scope and the next steps to realise your property investment goals.