Negative Gearing – it’s an emotive issue and much talked about, particularly for first time investors. But what does it actually mean and how can you benefit from negative gearing?
In a nutshell, negative gearing refers to the situation where the income received from an investment is less than the costs incurred… resulting in an overall loss. Come tax time, this loss can then be deducted from other income, reducing the amount of tax that would otherwise be payable.
On the flip side, an investment is considered to be positively geared if the income generated is more than the expenses incurred and tax on this profit is payable.
Negative gearing doesn’t just apply to property, any asset which earns income can be negatively geared, but property is by far the most popular form. Purchase of a share portfolio is another common way to negatively gear an investment and in this case the loss will usually arise because the asset has been purchased using a significant borrowing. This results in a large interest cost which can then be used to offset tax.
So, depending on your marginal tax rate, and the size of your annual loss the tax savings can be significant. For someone on the highest marginal tax rate (45%), you could save $45 of tax for every $100 loss. This sounds great in theory and is why many people explore negative gearing as an option.
Keep in mind though, if your investment is making a loss, it is costing you money and when your outgoings are higher than your incomings you will need another source of income to fund the difference.
Alternatively, if an investment is positively geared, you will be generating extra cash. You will pay tax on the additional income, but you do not need to fund the loss.
Before you rush into purchasing an asset in anticipation of a big tax refund, there are a number of other factors to consider. Such as:
- Can you afford to repay the debt?
- What if the value of the asset decreases? This can lead to you owing more than the value of the investment. If you have to sell, you may incur a loss and still have debt to repay without receiving any income.
- What if you lose your job and can’t afford to make repayments?
- Do you expect to make a capital gain? What is the tax impact of a large gain?
- What if interest rates rise? Will you still be able to afford to make repayments?
- Are you prepared for the investment to suddenly lose value? Assets lose value as well as increase in value. Are you willing to take this chance?
- Will government policy change?
- What if you earn no income from the investment (eg a rental property is vacant for a significant period)?
As with all financial decisions, receiving a tax advantage should not be your primary motivator. Tax policies and your personal circumstances can change and it may not be simple to offload an asset that is no longer serving you.
Do you have further questions about how a negatively geared investment might work in your circumstances? I’m more than happy to chat with you and offer a FREE 30 minute initial consultation. You can easily book online here and I look forward to helping you sort your finances!