How Does Negative Gearing Work?
Negative gearing with investment property and tax deductions sounds complex, but how it works is explained easily. Can it help you conquer the housing market?
Understanding Negative Gearing
Definition of Negative Gearing
Negative gearing happens when the cost of owning an investment property exceeds the rental income, meaning the homeowner is making a net loss. While this might sound like a failed investment, it is sometimes used as a deliberate strategy for tax deductions on rental properties.
Negative gearing is a gamble, with investors risking the short-term losses in the hope that they’ll be outweighed by long-term profits from capital gains from selling the property value increases.
Definition of Positive Gearing
Positive gearing is essentially the polar opposite investment property strategy: making a net profit from rental income that exceeds costs like loan repayments, maintenance and other fees (such as council rates). This is the best strategy for investors looking to make steady income without risking financial strain.
However, positive gearing is subject to tax, which reduces overall investment returns unlike the tax savings of a negative gearing strategy.
Tax Implications
The most significant difference between the strategies - and the reason negative gearing can be a successful investment strategy - is the fact that making a net loss on an investment property can be tax deductible.
This allows investors to offset it against other sources of income (i.e. salary income), reducing their overall taxable income and, therefore, income tax payable. On the other hand, positive gearing increases the investor’s taxable income.
Historical Context of Negative Gearing in Australia
Timeline of Policies
Negative gearing became a popular property investment strategy in Australia in the 1980s, barring a very brief hiatus from 1985-87 when the government removed tax deductibility for rental losses, removing the benefits of negative gearing. When these tax benefits were restored, it once again became a popular practice when investing in housing.
Key Legislative Changes Over the Years
In 1999, the government introduced a 50% Capital Gains Tax discount for assets held over one year, which complemented the benefits of negative gearing and incentivised more property investment. The strategy and the related legislations have faced criticism in recent years, particularly in times of housing affordability issues, but no new legislations have been introduced to prevent or restrict negative gearing.
Effects on the Housing Market
Impact on First-Time Buyers
Negative gearing has come under criticism for making it more difficult for first-time buyers to enter the market. Investors using this strategy tend to target affordable, entry-level property, which drives up the price and reduces availability of these options for first-time homebuyers.
Investors motivated by tax benefits and capital gains are more willing to bid higher on a house than first-time homebuyers, therefore pricing them out of the market.
High-Income Earners
High-income earners benefit disproportionately from negative gearing as they are able to absorb the short-term financial losses more easily, enabling the long-term financial gains. High-income investors are also able to invest in multiple properties, increasing their tax deductions and benefiting even more from capital gains.
Over time, this widens the economic disparity between lower-income and higher-income earners, potentially contributing to a housing crisis in future.
Effects on Rental Markets and Housing Supply
The impact on rental markets is debated, with some arguing that negative gearing incentivises investment and, as a result, boosts rental housing availability. On the flip side, critics claim that it drives up property prices without actually increasing housing supply.
Ultimately, when property values rise, rental prices are likely to increase and make rental properties less affordable. This can play a role in a housing crisis.
Benefits and Drawbacks
Benefits for Investors
When we combine negative gearing with the capital gains tax discount we mentioned earlier, it paints a very attractive picture for investors in Australia. Offsetting rental losses against other income can significantly reduce an investor’s overall taxable income, while the additional benefit of a 50% capital gains tax discount on assets held over one year further lowers the tax payable on any capital gains when the property is sold.
This creates a very attractive prospect for long-term investment properties with a focus on capital growth rather than short-term financial gains.
Risks and Drawbacks for Investors
Negative gearing inherently means cash flow losses, which can create sustained financial strain for investors. In addition to the short-term losses, there is a major reliance on the property value rising. If property value stagnates or decreases, investor losses could be significant.
There is also the risk of policy changes (particularly after a federal election) which could reduce the profitability of this strategy, such as reversing the capital gains tax discount or preventing property losses from contributing to tax savings.
Expert Opinions and Advice
Key Considerations for Investors
The first and most important consideration before committing to any investment property is your financial position and goals. Negative gearing requires sufficient income - either salary income or other types of income - to cover continued costs that won’t be offset by the rental income, meaning you need to be able to afford those short-term negative gearing losses.
It’s also vital that you understand the market you’re investing in, i.e. being able to identify high-growth areas where negative gearing presents the greatest opportunity as property values will likely appreciate.
Other factors such as interest rate fluctuations or potential tax policy changes after federal elections and maintenance costs will also have a significant impact on whether investment in housing as a negative gearing project is viable and beneficial.
Making Informed Investment Decisions
Being well-informed before making any decisions is a non-negotiable. The more you know, the better. But not everybody can be an expert in the complexities of property investment. That’s why turning to the services of specialists is the smartest decision you can make.
Take the time to consult with financial advisors and gain valuable insights into benefits, risks, tax implications and everything you need to know in order to make a safe, profitable investment. Our team at Mason Finance can offer you exactly that, starting with a FREE consultation to understand you situation, goals and the best next step for you as a property investor in the housing market.
Could negative gearing be a wise investment for you? Find out by speaking to our team of experts today.