There has been a bit of discussion on negative gearing in both the Australian and New Zealand media lately. So what exactly is negative gearing, how does it work and what are the pros and cons to having a negatively geared investment property?
What is negative gearing?
In a nutshell negative gearing is when a property investor borrows funds to purchase an investment property, and the cost of holding and managing that investment property is greater than the gross income the property brings in. Costs also included tax depreciation on the property and interest charged to the loan, but not the cost of the principal (capital repayments).
In Australia and New Zealand, costs incurred in earning income are generally tax deductible, so negatively geared properties afford investors certain concessions.
How does negative gearing work?
According to taxpayer.com.au, if an investor has a net salary after tax deductions of $50,000 and borrowed $102,000 at 10% interest a year to buy a property. Income from this investment property for the year comes in at $6,240 (which is after deductible expenses other than interest).
|plus net rental receipts||$6,240|
|Total assessable income||$56,240|
|less interest deduction||-$10,200|
|Tax payable (excluding Medicare)||$7,362|
The tax payable on the $50,000 net salary without the negatively geared investment property would otherwise be $8,850, so $1,488 less has been paid in tax.
For more information on negative gearing in New Zealand, visit ird.govt.nz.
When to use a negative gearing strategy
If you have the funds to cover the shortfall between the cost of holding the property and the rental income, then you may be able to purchase a negatively geared property.
Negatively geared properties have certain tax benefits as detailed above.
Holding a negatively geared rental property long-term may see the investment gain capital growth, or become a positively geared property if the local rental market changes. However there are no guarantees which is why this strategy is sometimes called speculative investing.
The very nature of negative gearing means your investment property is essentially being held at a loss.
Negative gearing requires you to have the income to make up the shortfall between the cost of holding the property and the rental income, so if this shortfall is made up of income from elsewhere this strategy may not be suited to those close to retirement or about to leave the workforce.
While the debate on whether or not positively or negatively geared investment properties are the better option for investors, the truth is there is no definite answer. Both have their merits and drawbacks, and both cash-flow structures are currently possible in both Australia and New Zealand.
It really comes down to your financial situation and the type of investment property you are considering.
There are two schools of thought – one is capital growth the other is positive cash flow, negative gearing probably appeals more to those looking for eventual capital growth – as some areas with promising capital growth opportunities don’t necessarily promise positive cash flow.