Negative Gearing

It sounds like the results of a rookie mechanic who couldn’t properly put your vehicle’s transmission back together, but “negative gearing” is just one more term we’ve had to learn during the past decade of evermore complex financial tools and products. But in simple terms, it simply means “borrowings.”

The more that’s borrowed the more “geared” an investment is said to be—and the higher the risk. The word “negative” refers to the fact that income from the investment is less than its costs. Usually the term is used in reference to an investment property, but it could also describe a share portfolio or a business.

But, if an investment is losing money, what’s the point of it?
Good question. The point is that the loss sustained by the investment can be used to offset income and thereby reduce your personal tax, as the example on page 18 demonstrates.

Naturally, in this example, the investor has to contribute some of his own cash toward the project, probably around $4000 pa, as the depreciation item doesn’t represent a cash item. Hopefully the property will be appreciating, offsetting the loss over the longer term. In the meantime, the investor needs to be certain of his own income before launching into such a venture.

The much-debated question around negatively geared investments is whether or not to use an interest-only loan. The argument in favour hinges on not wanting the investment to become positively geared and thereby lose the tax advantage. Exponents suggest that only minimum payments should be made in order to save cash for the next investment. The theory goes, that as the property increases in value, so your equity grows. This equity can then be used to fund further borrowings for more investments.

Alternatively, the loan can be paid off like a regular home mortgage before further investments are made. The rationale here is that there is no point heading into retirement with debt.

Whatever your philosophy, the consensus on the topic suggests that any investment should be entered into on the merits of the investment rather than being simply tax-driven. Remember, a negatively geared investment loses money, and losing money is not the way to get ahead financially, even if the loss is softened by tax relief.

The final word goes to Noel Whittaker whose book Making Money Made Simple (Simon & Schuster, 1987) encouraged many Australians to take their own financial wellbeing seriously:
“It is important to understand that gearing will increase the amount of any loss if prices fall. Buy an $80,000 house with $5000 deposit and you have doubled your money when the price reaches $85,000. If the price falls to $77,500 you have lost 50 per cent.

“Almost everybody who started with nothing and achieved wealth has done it with gearing, but the art of maximising profits is to achieve the right amount of gearing. The amount of gearing depends on three strengths. First, the strength of your income. Second, the strength of your total assets. Third, the strength of your nerves.”

Two excellent books on the topic from publishers Wright Books are Negative Gearing, by N E Renton (1998), and Rental Property and Taxation (1998).

negative gearing at work

Property value $150,000
Amount borrowed 150,000
Annual rental income 10,400

Annual Expenses
Interest $10,500
Rates 1,000
Insurance 500
Agent’s fees 800
Maintenance 500
Depreciation 4,000
Annual loss $7,900

If your marginal rate of tax is:
31.5% your tax return will be $2,500
43.5% your tax return will be $3,400
48.5% your tax return will be $3,800

Extract from Signs of the Times, March 2003.

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Money Matters - with Doug Burns

Negative Gearing