Selecting a property with different gearing structures is an important part of an investor’s journey. Experienced property investors will likely have a mix of positive and negative geared properties to create a balanced portfolio.
A property is geared to be either negative or positive, which essentially means the property either brings in a positive or negative income.
Positive gearing:
A positive gearing situation exists when the property puts money in the investor’s pocket each year, after all expenses have been paid and tax deductions included to produce tax savings (income). This is excellent because it does not require a cash shortfall to fund the asset, which is growing in value over time (i.e.: no expense for complete capital growth return). It is important to note that the surplus income does contribute to your annual taxable income figure, and therefore will increase your income tax paid to the ATO come tax time. Because of this, it may not achieve your property’s objective if you are a high-income earner looking to divert tax funds elsewhere.
But as we say, paying tax is often a good sign, because it means you have made money! Further to this, positive geared properties typically do not hurt an investor’s borrowing capacity and may permit their portfolio to expand quicker, as there isn’t a continual drain on cashflow through each property’s combined shortfalls.
Negative gearing:
The term ‘negative gearing’ refers to a situation where the day-to-day cashflow from the investment is less than the cost(s) of the investment, thus the investment is producing a day-to-day (annual) loss. In practical terms, this occurs when the rental payments do not quite cover the running expenses (interest on the money you borrowed plus running expenses). The loss is forecasted to be negated over the long term by the increase in capital growth, which would more than exceed the relatively small out of pocket expense incurred annually to hold the property. Also, although individually incurring a loss, the negative geared property can be used to offset your regular income (eg: wages and salary), therefore reducing total taxable income and tax payable to the ATO. Alternatively, the negative geared property might be used to balance out income produced from positive geared properties, so that the net holding cost of your portfolio is neutral.
Combining the two concepts:
Investors often classify their property as negatively/positively geared based on before or after tax calculations. An investment that is positively geared before tax, means that the investor is left with no cash shortfall at all during the year. However when non-cash expenses (deductions) such as borrowing costs and building deprecation are taken into consideration, the property may incur an ‘on-paper’ loss, a thus being deemed as negative geared after tax.
Alternatively, a property may be negatively geared before tax, with the investor having to fund a cash shortfall throughout the year because rental income doesn’t fully covering the property’s cash expenses. However when non-cash expenses are taking into account, thus generating tax savings from the government, a property may actually turn positive geared if the saving in tax outweighs the cash shortfall incurred. In this situation, the property has not increased an investor’s taxable income directly through it’s own income, but has benefited the investor by saving them funds usually paid in tax.
Another situation often occurs when property starts out negatively geared, but after a few years becomes positively geared as rental income increases or interest rates reduce over time.
Pros and Cons of Gearing:
Let’s have a top-line look at the benefits of each situation:
| POSITIVE GEARING | NEGATIVE GEARING | ||
|---|---|---|---|
| Pros | Cons | Pros | Cons |
| • No strain on investor’s normal cash flow | • Income contributes to an investor’s taxable income, which limits the savings in tax by having the investment | • Loss can be used to offset regular income such as salary | • If the investment does not acheive required rental returns, the drain on cashflow may be too great and impact on your lifestyle |
| • Does not compromise an investor’s borrowing capacity | • Need to be able to meet the regular interest costs associated with your borrowings regardless of rental income which may change if tenancy changes. It is best not to rely solely on the income from your investments to cover these costs as this income can be unpredictable and interest rates may rise | • Investment can help amplify total return on investment when capital growth is taken into account | • Tax advantages may vary if tax rates and/or government policies change |
| • Can help balance out a property portfolio by neutralising negative geared property(s) | • May not necessarily exist with high capital growth also | • Very small holding cost for large long-term gain, while securing maximum tax benefits | • If the property does not acheive the expected capital growth in value, you will have suffered a net total loss on the asset. |
| • Can help balance out a property portfolio by neutralising positive geared property(s) | • Gearing will increase your portfolio’s risk profile, and reduce borrowing capacity if too many held | ||
What is right for you?:
Investors are given a lot of advice from the media, and every mate who’s an ‘expert’, but the simple answer is that everyone’s investment goals and income scenario are different – there is no ‘one size fits all’ approach. Often investors fall for immediate tax benefits without understanding the long term implications, whilst other investors do the opposite.
Some investor’s goals are to reduce their taxable income, others to build wealth over a short time frame. Some only plan to own one or two investment properties, whilst others need enough positive cashflow to purchase 10 or more. Some aim to sell properties in the near future, whilst others are planning to hold onto them for the next 40 years.
Unfortunately there is no magic answer on whether to negatively or positively gear a property to suit everyone. Personal circumstances and the property market can fluctuate, which can also impact what is the best option. Most investors look at diversifying their investments with some properties negatively geared, whilst others are positive. Some investors purchase through self-managed super funds which makes the decision even more crucial.
Make sure you seek professional advice and look at the short term and long-term pros and cons. It’s important to make sure you understand how and why, when making any decision related to your investment. Property investment should always make you money, but the difference in how you gear a property can play a significant part in how big the returns are.