Negative Gearing: What Is It and How Does It Work?

Negative gearing is a financial strategy commonly used by rental property investors. It occurs when the rental income generated from an investment property is less than the costs associated with owning and maintaining it, including mortgage interest and maintenance expenses. In this scenario, the investor incurs a loss, which can potentially be offset against other income, like their salary, to reduce their overall tax liability. While negative gearing can offer tax benefits, it also relies on the assumption that the property’s value will appreciate over time, helping the investor realize a profit when the property is eventually sold. For help with your own investment portfolio, talk to a financial advisor .

Negative Gearing Explained

Negative gearing is a strategy primarily used by investors who purchase assets , most commonly real estate, with borrowed money. The term refers to a situation where the expenses related to holding the investment exceed the income the investment generates. These expenses typically include mortgage interest, maintenance costs, property management fees and other associated outgoings. By borrowing to invest, an individual aims to build wealth over the long term through capital growth, rather than immediate cash flow.

The loss incurred from negative gearing can often be used to offset other taxable income , such as wages or a salary. This reduces the investor’s overall tax burden.

The core idea behind this strategy is that, while the investment may generate a loss in the short term, it is expected to grow in value over time. Investors hope that the long-term appreciation of the property will more than compensate for the short-term losses, leading to a net gain when the asset is eventually sold. However, this strategy comes with risks, including market downturns and unexpected costs, which can affect the projected returns.

Example of Negative Gearing

Consider an investor who purchases a rental property for $500,000 with a $400,000 loan. The annual rental income from the property is $20,000. However, the total annual expenses-including mortgage interest, maintenance and other costs - amount to $30,000. This means the investor is operating at a loss of $10,000 each year.

With negative gearing, this $10,000 loss can be deducted from the investor's other taxable income. For example, if they earn $100,000 from their job, their taxable income would be reduced to $90,000.

While the property generates a short-term loss, the investor hopes that over time the property's value will increase. If the property appreciates and is sold for $600,000 a few years later, the profit from the sale could outweigh the initial losses, making negative gearing a successful long-term strategy in this scenario.

Advantages of Negative Gearing

Negative gearing provides more than just short-term relief from tax burdens; it can be a strategic tool for investors seeking to optimize their portfolio's long-term growth. By leveraging this strategy, investors may benefit from both immediate tax deductions and future capital gains, making it particularly attractive in markets where property values are expected to rise.

Below are some of the key advantages of negative gearing, particularly focused on the potential for tax efficiency and wealth accumulation over time:

• Tax deductibility : The primary advantage is the ability to claim tax deductions on losses incurred from the investment. By offsetting rental property expenses-such as mortgage interest, maintenance costs and depreciation-against other income, investors can reduce their taxable income, which effectively increases cash flow in the short term.
• Potential capital gains : Investors aim for long-term capital growth, where the property’s value appreciates over time. While incurring short-term losses, the ultimate goal is to profit from selling the property at a higher price in the future.
• Maximizing leverage : Negative gearing enables investors to use borrowed funds to purchase a higher-value asset than they could with equity alone, amplifying the potential return on investment through both capital growth and tax savings.
• Tax benefits on asset depreciation : Investors can also claim depreciation on the property, which further reduces taxable income without impacting cash flow, increasing the overall tax benefit of the strategy.

Risks of Negative Gearing

Negative gearing can be a powerful tool for investors, but it's important to recognize the inherent risks that come with it. This strategy involves not only short-term financial losses but also an increased exposure to market forces, interest rate fluctuations and the potential for limited liquidity.

While it offers tax advantages, the following risks of negative gearing can complicate the path to profitability:

• Ongoing financial losses : Negative gearing involves accepting consistent losses in the short term, as rental income typically does not cover the full cost of property ownership. This can put pressure on cash flow, especially if unexpected expenses arise.
• Dependence on capital growth : Negative gearing relies heavily on the property increasing in value over time. If property prices stagnate or decline, the investor may face losses without the anticipated capital gain.
• Market volatility : Real estate markets are subject to fluctuations due to economic conditions, interest rates and regulatory changes. A downturn in the market can significantly impact an investor’s return.
• Interest rate risk : Rising interest rates can increase mortgage repayments, exacerbating the losses and reducing any potential tax savings.
• Limited liquidity : Property is an illiquid asset, meaning it cannot be easily or quickly sold if the investor needs to access funds. This could pose a challenge in times of financial stress.

Negative Gearing vs. Positive Gearing

While negative gearing involves an investment where expenses exceed income, positive gearing refers to the opposite scenario: where the income generated from an investment , such as rental property, exceeds the costs associated with owning it. In a positively geared property, the rental income is greater than mortgage payments , maintenance and other expenses, providing the investor with immediate cash flow that can either supplement their income or be reinvested.

The primary difference between the two strategies lies in their financial approach. Negative gearing focuses on long-term capital growth, with investors willing to accept short-term losses for potential future gains. Positive gearing, on the other hand, is more conservative, offering a steady income stream but potentially less opportunity for significant capital appreciation.

Bottom Line

Negative gearing is a strategy that allows rental property investors to manage short-term financial losses in exchange for the potential of long-term gains, particularly through tax benefits and property appreciation. While negative gearing can reduce taxable income and offer opportunities for wealth creation, it also exposes investors to risks, such as ongoing cash flow pressure, interest rate changes and market fluctuations.

Tips for Real Estate Investing

• Negative gearing can be complex and understanding its impact on your financial strategy can be challenging. Finding a financial advisor doesn’t have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
• Whether you’re looking to leverage negative gearing or build a solid real estate portfolio, a mortgage calculator can be an invaluable tool. It allows you to estimate your monthly repayments, compare different loan scenarios, and assess the potential impact of future investments.

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