In the financial world, we use the term ‘gearing’ when we borrow money to invest and it’s very typically talked about in the context of investing in property. Gearing is leverage or simply borrowing money, where it’s measured by various leverage ratios, such as the debt-to-equity ratio. A property is going to be either positively or negatively geared depending on the amount we’ve borrowed, the interest rate we’re being charged, the associated costs of property ownership, and the rental income we’re receiving.
A property is positively geared when the rental return (the money you receive from your tenants) is higher than your mortgage repayments and all the other property-related expenses (e.g. insurance, strata, council rates). On the other hand, the property is negatively geared when your rental income is less than your interest repayments and those property-related expenses.
There is such a thing as a neutrally geared property, but only if all the expenses and income are equal.
“So, therefore, buying a positively geared investment property must be the best way to go?”
Well, funny you should say that because that’s not entirely correct. Let me unpack this.
Positively geared property
The income you get from a positively geared property can put more money into your pocket and at an initial glance it can make you feel more confident that you are going to make all your loan repayments and possibly have money remaining. You also might get gooey-eyed at the thought of the extra money and start spending it on other things for yourself. But keep in mind that if your property is positively geared the net rental income will still be subject to income tax and it might put you into a higher tax bracket.
Negative gearing benefits and considerations
The key benefit of negative gearing is that any net rental loss you incur during the financial year may be offset against other income you earn, such as your salary. This in turn can then reduce your taxable income and ultimately how much income tax you have to pay.
Expenses you can claim as tax deductions
As a general rule of thumb, you can claim the interest bill of your loan repayments, and provided the property is rented out the other rental expenses can be claimed as tax deductions. This works the same way that any business has claimable items for running the business. These items cover things like insurance, management fees, legal costs, council rates, and maintenance. They are claimable because they are business expenses.
Capital Gains Tax
Just like you’ll pay tax if you earn rental income from your investment property, you’ll also pay tax on any profit you make when you eventually sell this investment property. When you make money from selling your investment property, your profit is referred to as a capital gain and the tax on this amount is called capital gains tax (commonly abbreviated to CGT).
How much CGT you pay will depend on a few factors. But with your fabulous accountant by your side the entire way through your investment journey, you’ll be well prepared (did you get the hint that you need to have an accountant). But as a teaser for you, if you sell at a profit after owning the property for more than a year the lovely folks at the tax office will, under normal circumstances give you a 50% discount on your CGT.
Positive or negative gearing – which option is best for you?
You shouldn’t decide which is right for you just from reading this blog. And it’s also not a decision to be made after a chat on a Sunday afternoon BBQ with that well-meaning friend who just so happened to have googled it last week.
Positive and negative gearing strategies both have benefits and drawbacks, and it’s going to change over time and depend on your personal circumstances, current income, debts, and what your risk preferences might be at that moment in time. To find out more about what you can and can’t claim on a rental property you’ll need to involve your investment team, accountant, financial advisor, and your lovely Blue Wealth Property investment property specialist for personalised advice. Consult with your finance team to make that decision but know that part of being a clever investor is knowing that your portfolio will need to be reviewed over the years.
Knowledge is Power
Owun is the Senior Education Specialist at the Blue Wealth Property Academy and hosts The Clever Investor podcast. He has worked in finance and property for well over 20 years and is known for his ability to explain the complex world of wealth creation in an easy-to-understand way.