Smart Investor: Getting Started, August 2011

Smart Investor, August 2011. Getting Started: Negative Gearing

If you were to key ‘negative gearing’ into Wikipedia – and, let’s be clear, you should never get your investment advice from Wikipedia – you’d get three short and rather dismissive paragraphs. But if you then followed the link to ‘negative gearing (Australia)’, you’d get 2,600 words of technical and even moral discussion and debate. There is truly nowhere else in the world that is so obsessed with the idea of negative gearing as Australia.

What does it mean, and is it right for you?

Negative gearing is a simple enough concept: if the costs of owning a property, including the interest on your loan and the usual maintenance and repair work, are greater than the income you get from that property, then you are negatively geared.

In Australia, a whole industry exists around encouraging you to do exactly this, for tax reasons. Generally speaking, if you’re making a loss on your property, you can set that loss against tax. Specifically, you can (in some circumstances) make deductions in three areas: revenue, including interest on the loan as well as maintenance, agent fees, council fees, body corporate, insurance and bank fees; claims for capital items, such as white goods; and claims for building allowances. (These last two categories get you into the world of depreciation, which is a whole other subject – basically, the gradual deterioration in value of assets, from your fridge to an extension you’ve built on your house, can be turned into a tax deduction spread out over many years, subject to very specific depreciation schedules set by the ATO.)

Negative gearing is very popular in Australia, despite the fact that in most countries (Canada and New Zealand are exceptions) it is not accepted practice, and the fact that most people in other countries think it patently absurd to engineer a situation in which you’re making a loss on an investment on purpose. Its popularity in Australia stems from the fact that taxes are high and pervasive here, so that anything that can reduce the tax bill can, in some circumstances, make sense. As you pay your mortgage month after month, your equity in the property increases, until one day you sell the property at a major capital gain having not incurred tax bills along the way in building your investment.

Anyone considering it must be aware that negative gearing comes with a significant risk. For a start, you’re borrowing to invest; that always carries a risk, because it has the potential both to increase gains and losses. Secondly, if you’re negatively geared, then you’re already putting yourself in a position where you have to be able to meet your losses on the property from some other source. You need to be very sure that source is going to be resilient, because if it doesn’t, you’re not going to be able to meet repayments on your property. And – this is perhaps the point that is most easily overlooked – by negatively gearing, you have already made yourself vulnerable; if things change, such as the loss of a tenant, or a decline in your asset value, or a sudden rise in interest rates, you are more vulnerable too. You must be sure that your finances will be able to withstand such changes. One way to improve your standing in this respect is mortgage protection insurance, or landlord insurance, or some combination of the two.

Negative gearing doesn’t just apply to property: it can equally be applied to share market investments, for example. But the principles are the same, and these words from the ASIC consumer site, moneysmart.com.au, are worth remembering:

“Tax benefits alone are not a good enough reason to gear an investment. To profit from negative gearing, you must turn this yearly loss into a profit sometime in the future. If you aren’t sure of this, the investment is really not worth your time.”

Box: How it works.

You have a property generating an income of $2,500 per month. However you are paying $2,300 a month on your mortgage, and $500 a month in other costs such as fees to an agent, council rates, and general maintenance. Your outgoings, at $2,800 per month, are greater than your income, at $2,500 a month; you are negatively geared.

You may be able to set your net loss of $300 a month, or $3,600 a year, against your tax bill, though you will need advice on your own circumstances. This is appealing because of the alternative: if you were, instead, clearing $300 a month in profit on the property, that would be taxable income, increasing rather than reducing your tax bill.

You will, though, be having to meet that $300 a month from some other source of income.