What is negative gearing?

June 20, 2012, 11:57 am David Koch Yahoo7

Negative gearing is something Aussies love to talk about when it comes to property. Thrown around at a party and it causes a lot of people to nod knowingly.

However often the nodders don’t really know what it means. If you happen to be one of them, read on and we’ll clear that up.

Negative gearing is basically where you borrow to invest, and the amount of rent you get from the property over the year is less than the amount you need to pay on the loan. The good news is that there can be significant tax advantages if you can negatively gear an investment property. The bad side is that people often get over excited about the tax break and forget the risks involved.

If you negatively gear a property, the costs of owning that investment property are tax deductible. That includes the interest you pay on your mortgage over the period, property management fees, and maintenance costs. As you would know if you’re in the property market already, these costs add up very quickly.

When it comes time to do your tax return, the negative income from the investment property can offset other income and reduce your overall tax bill. If you fall in a high tax bracket this can be of serious value, both in dollar terms and moral one-upmanship on the tax man.

To give some basic context to it all, let’s take an investment property bringing in consistent rent of $350 per week on a mortgage requiring $500 repayments each week. Over the year, the property will have a negative gap of $7,800. This is the amount of the tax deduction available to the owner, who, if in a high tax bracket, could save up to half of this.

It all sounds pretty good so far doesn’t it? Getting your hands on an investment property with a tax break to boot.

But while negative gearing does have great tax benefits, it’s not a sure fire way to make money by a long stretch. There’s no such thing. Remember, it’s a loss-making investment. The “negative” in negative gearing means there is a cash outflow every month. So you need the cash flow from elsewhere to cover that, which is way before you can claim the tax benefits.

The key to negative gearing is this: never invest because of negative gearing. Treat it as a bonus, not a reason to invest. Otherwise you might find yourself in some trouble.

You only have to look back a few years where the serious slump in US property prices was one of the catalysts for the global recession. This was a resounding lesson on the pitfalls of highly geared property investing.

What investors with negatively geared property are hoping for is that one day the rent covers the whole loan cost, or that the capital growth in the property is big enough to cut a profit when they sell out. These are quite plausible outcomes, but no certainties.

The key to turning the odds in your favour is to buy a quality property in a good location. The old adage to buy the worst property in the best street still rings true, as does the phrase location, location, location.

If possible, buy a property in a well-established suburb, where property prices don’t fluctuate wildly. This will help you feel comfortable that when it comes time to sell the property you’ll make a decent return.

Taking a well researched, cash-flow considered approach to negatively gearing an investment property can be a great way to invest, just don’t be oblivious to the risks involved.


Related: More from Kochie -
5 ways to slash your home loan.
How & Why: Refinance your loan.

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