Negative Gearing in Simple Terms
Negative gearing is a part of life for some investors, and a property buzzword.
So what is it?
Gearing simply means borrowing money to buy an asset such as property.
Negative gearing means the annual interest payable on the loan used to acquire the property plus other expenses incurred in maintaining the property exceeds the annual rental income the property generates. As a result you are making a loss.
Neutral gearing means that the interest and expenses you are paying on the loan are equal to the income.
Positive gearing means that the interest you are paying on the loan and expenses are less than the income. As a result you are making a profit.
So, if negative gearing means that you’re making a loss, why is that a positive for some property investors?
Nobody wants to invest in property to lose money. However, with negative gearing the financial benefit comes from the capital growth (increase in property value).
You purchase an investment for $450,000 @ 6% equals $27,000pa in interest payments.
The market rent achievable is $400pw equals $20,800pa.
Without taking into consideration expenses, you are making a $6,200 loss on the investment. That is the bad news.
The good news is the tax advantages for high-income earners and that the property should be appreciating. If the property value increased by 5% i.e. $22,500, your position at the end of the year is $16,300 increase/profit.
It would be great to be neutrally or even positively geared and still make a net profit, but sourcing these properties can sometimes be hard to find.
In summary, negative gearing works if the money you make from the capital growth is greater than the loss you make in rental shortfall.