How does negative gearing work?

If you’ve just dived into property investing, you might’ve encountered the term ‘negative gearing’.

In simple terms, negative gearing means a property’s expenses exceed its returns. In other words, if your property is negatively geared, it’s costing you more money than you’re making from it.

While the concept might seem pretty straightforward, there are a few complexities to it. Here’s what you need to know about negative gearing, how it works, and its advantages and disadvantages.

What is negative gearing, and how does it work?

First up, it’s helpful to understand exactly what ‘gearing’ is. It simply refers to borrowing money to invest in an asset – such as property.

When you own an investment property, you’ll likely rent it out to receive rental income. If your rental income ends up being less than your home loan interest repayments and other property expenses (like repairs, maintenance, insurance, council rates, and property management or other real estate fees), it’s considered a negatively geared investment. In short, you’re effectively making a loss on the property.

This might sound completely illogical, given one of the primary points of owning an investment property is to make money from it. But, for investors, there are several advantages to negative gearing – particularly tax benefits.

It’s worth noting that negative gearing doesn’t just relate to property. It can apply to any other kind of investment, like shares.

Negative gearing is also different from property depreciation (the property’s decline in value), which is another deduction many rental owners claim to further their tax savings.

Are there any benefits of negative gearing?

For investors, yes. Many Australian property investors use negative gearing as an investment strategy. Here are two of its main advantages.

You may reduce the amount of tax you pay

According to Australian Taxation Office (ATO) data from the financial year 2020-21, out of the more than 2.2 million rental property owners in Australia, just over 1 million recorded a net rent loss in their tax returns.

One of the principal reasons investors use negative gearing is that they can lower their taxable income by claiming the property’s expenses and losses against their earnings. The result is that they typically have to pay less income tax.

The property might experience significant capital growth

Generally speaking, investors purchase negatively geared properties in areas likely to experience strong capital growth in the coming years, meaning property values go up. This (ideally) allows them to sell the property for a higher price than they purchased it, covering any losses associated with owning it.

However, if the owner profits from the sale, they’ll have to pay tax known as capital gains tax (CGT).

Does negative gearing have any downsides?

Like any investment strategy, negative gearing is not without its risks. There are several factors to consider before adopting a negative gearing strategy.

Your personal income or cash flow needs to be high enough to cover the shortfall

Because the property won’t be producing an income, you’ll need to ensure you can cover ongoing expenses, unexpected costs (like damage and fluctuating interest rates) and your loan repayments. This can be especially tricky if there are periods when the property is unoccupied.

The property may decrease in value instead

Despite your best efforts to scout out a home in a growth area, there may be factors out of your control – like a downturn in the property market or oversupply – that cause your investment property to fall in value.

What’s positive gearing?

If your rental returns more money than it’s costing you, it’s a positively geared property. While this does mean you’re able to make money in the short term and comfortably pay off your home loan, the money you receive from rental returns will be included in your earnings at tax time.

A property can also be neutrally geared. This means the income you get from it and the money you spend on it are more or less equal.

Do positive gearing and negative gearing only apply to an investment property?

In most cases, yes. Positive and negative gearing are only applicable if you receive income from a property.

This is why your home (referred to as your ‘main residence’) usually isn’t subject to either of them. You also can’t claim your home’s expenses as tax deductions, and if you sell your home, CGT won’t apply.

That being said, there are a few cases where positive or negative gearing might come into play.

If you’re renting out a spare room, office or garage, for example, you’re technically using part of your home to make money – and you may be able to claim this portion of your home as an income-generating asset. The same goes if you move out of your home and convert it into a rental property.

Just note that if you’ve earned income from your primary residence and decide to sell it, you may have to pay CGT. Chat with your accountant for advice.

If I’m paying off a home loan, does negative gearing apply to the principal, interest or both?

Negative gearing only applies to the interest on your investment loan. This means that come tax time, you can only claim your interest repayments.

It also means you’ll need to be able to afford the principal repayments comfortably or consider refinancing to an interest-only loan.

If you’re ever unsure, chat with your accountant, a financial adviser or a mortgage broker for guidance on your personal circumstances and financial situation.

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