A surge in residential property investment has put negative gearing back in the spotlight. So how does it work — and is it a smart choice for you?
Australia’s recent housing boom has been driven by investors as much as home-buyers. According to the Australian Bureau of Statistics, investment loans hit record levels in June 2017, making up more than half of all new housing loans, including more than 60% of loans in New South Wales.
And, while those numbers fell back in July as regulators acted to rein in investment lending, there’s no doubt investor interest remains strong.
Surging prices have seen rents struggle to keep pace. According to the CoreLogic RP Data Home Value Index, annual rental income from investment properties fell to an average of just 3.3% of house prices in August — more than the interest on a typical term deposit, but less than the dividend yield on many shares.
That suggests many investors may be using a negative gearing strategy, sacrificing short-term income for long term gains.
But while negative gearing can be a powerful tool for building wealth, that doesn’t mean it’s for every investor or every situation. Here’s how it works, and how to decide if it’s right for you.
How it works
Gearing is simply borrowing to invest. As many home-owners know, it can be a winning strategy because it enables you to buy bigger and more valuable assets with less cash upfront, so you can potentially earn more income and make larger capital gains.If the income from your investment is higher than your borrowing costs, you’re said to be positively geared.
But, if you pay more in interest and other costs than you earn from your investment, you’re negatively geared. In other words, negative gearing means making a loss on your investment today in the hope of making a gain tomorrow.
So how can you use it as a strategy to build wealth?
Multiplying your gains
The key is that rental income is just one of the ways you can make money when you invest in property. The other, often much larger, money-spinner is the gain you make when you eventually sell, always assuming the property has risen in value. That’s because gearing also has the effect of multiplying your capital gains.
Here’s a simple example. Let’s say you invest $500,000 in a property and it rises 10% to $550,000, you make a 10% capital gain. But if you invest $100,000 of your own money and borrow the rest, that $50,000 profit is 50% of your initial investment — 10 times the capital gain. For investors, this multiplying effect can often outweigh the short-term losses that negative gearing involves.
But there is also a downside. Just as gearing multiplies your gains when you invest successfully, it also multiplies your losses if an asset falls in value. And remember that house prices can and do fall, especially after a period of strong gains. That’s why gearing should always be used as a long-term strategy, allowing you ride out any short-term ups and downs in the market.
Of course, the other reason negative gearing is popular with investors is that it can bring sizeable tax concessions. That’s because investors can generally claim a tax deduction for their interest and costs.
For example, if you’re in the highest 49% tax bracket (including the Medicare and budget repair levies), and you’re paying $20,000 a year in interest and other costs, you could receive a tax concession worth $9,800, making that expensive property look much more affordable.
So, while you may be making a loss today on your negatively geared investment, you can offset that loss against your other taxable income, lowering your overall tax bill.
But an important word of warning: tax laws are complex, and everyone’s situation is different. So it’s essential to get professional tax advice before you commit. And, while the tax concessions can make your strategy more effective, it is never a good idea to let tax influence your investment decisions.
After all, a bad investment with tax concessions is still a bad investment.
Getting great advice
As you can see, making gearing work is all about getting the numbers right. That’s why it makes sense to talk to a professional who can help you stress test your strategy and find the most rewarding option with the least risk.
A financial planner can help you create a tailored plan built around your individual situation — helping you take advantage of the benefits while avoiding the pitfalls.