What Is Negative Gearing?
“Gearing” means borrowing, using an asset as security for the loan. In this context it usually means a house or other real estate, or shares or similar investment asset, or an enterprise.
The “Negative” part of the term refers to an investment which is running at a loss. In other words the income or profit is less than the expenses (i.e. negative), after interest on the loan is taken into account.
Why Does Negative Gearing Matter?
The reason negative gearing became popular, especially in the purchase of rental properties and shares, is that when structured correctly, the loss on a negatively geared investment is tax deductible. Furthermore, under current rules, the losses can be offset against other income.
This means less tax is paid, effectively reducing the impact of the loss.
The gearing aspect is a crucial factor.
There is a potential benefit to be gained from accessing higher investment values by using a loan. For most of us, it’s quicker than saving up and paying cash for an investment, and brings forward the possibility of upside asset value increases and magnified income.
However the simple attraction of a tax reduction has lead to an undue emphasis on negative gearing as a tax planning technique, most often driven by commission agents or advisers, without due regard to the downsides and risks.
So What Are The Risks of Negative Gearing?
The downsides to negative gearing include:
- all gearing (borrowing) increases financial risk. There’s a myriad of real-world difficulties which can arise while paying off a loan, including risks to the stability of your income sources, and the adverse movement of interest rates
- negative gearing is by definition “negative”, even after the tax benefit. It means there must be some way to feed the cash flow losses from income or cash sources over and above the yield on the investment
- unless the potential profit earned on the investment at some point exceeds the sum of ALL the losses, there’s no point. This is the investment risk, e.g. that real estate or share values won’t go up by as much as you expect. Tax deductions won’t put food on the table.
What are the gearing alternatives?
A lower-risk way to approach geared investing is to positively (or neutrally) gear the investment.
A positive gearing means that although a loan is used to partly finance the investment, the investment income exceeds the costs, and to that extent provides a risk buffer.
The higher the profit, the lower the income risk, but this doesn’t necessarily have an immediate impact on the investment risk. Positive gearing won’t fix a dud investment, if the asset value goes down for any reason.
PAYG Instalment variations
On approval from the Tax Office, the tax offsets generated by an allowable negative gearing loss can be taken into account when calculating an employee’s tax instalments.
This can improve cash flow by returning the tax benefits to the investor/employee sooner, as opposed to waiting until after the end of the year for a tax assessment. See how to do this at Reducing PAYG payments
This page was last modified 2020-10-16