Owning an investment property has various costs associated with it. These include the interest payable on your investment loan, maintenance costs, the money spent on finding tenants, any council or strata fees, and the insurance premium for the property. There are also depreciation costs associated with a property. As a house gets older, the building undergoes wear and tear and loses value. It is the same with the items inside the building – such as a carpet, washing machine or dishwasher.
Even though an investment property requires ongoing payments, it also earns you money in two ways – rental income and capital gains. While rent can be a source of continuous income, capital gains refer to the profit you make when you finally sell the property.
Generally, you want the rent you earn from an investment property to be more than your costs, also known as positive gearing. You can use the extra cash flow to pay your mortgage or meet other financial requirements.
But did you know only a fraction of investment properties in Australia are positively geared?
According to the Australian Taxation Office (ATO), only about 40% of Australian investment properties are positively or neutrally geared. This means the remaining 60% of investment properties are negatively geared, which implies the rental income from tenants doesn’t cover the cost of the property. Still, negative gearing remains a popular investment strategy with property investors who want to maximise their tax deductions.
What is negative gearing, and how does it work?
An investment property is negatively geared when the interest on the loan to finance it and other costs are more than the income received. However, the ATO allows you to offset these losses against your taxable income.
For example, if you rent out a property for $600 per week, your total rental income for the year will be around $31,000. Assuming that you spent $50,000 on the property in this period, your total loss equals $19,000.
But the good part is that you can use this loss to reduce your taxable income. In the above example, you can calculate your negative gearing benefit by multiplying your total loss with your marginal tax rate.
Why is negative gearing so popular, and is it good for you?
Negative gearing has become extremely popular as a tax-saving scheme with property investors. They think spending more on a property is okay because most expenses are tax-deductible. Investors who use negative gearing also rely on capital gains to make good any short-term losses when selling the house.
Whether or not negative gearing is suitable for you is debatable. While it can help you manage your cash flow, you may end up spending more on an investment property if you are only chasing tax deductions and not focussing on maximising returns.
The main point is that you should not choose negative gearing solely for tax deductions. You may prefer this strategy if you are looking at capital gains and want to buy a house in an area with potential for capital growth. But the plan could backfire if property prices don’t grow as you anticipated.
On the other hand, a positively geared property will give you returns from day one. While you won’t get any tax deductions, you’ll build an extra source of income. Besides, you won’t be outlaying any of your own funds, and you can still benefit from capital gains, as most properties tend to increase in value over time. Thus, your aim should be to own a positively geared property if you wish to earn an income from your investment.
It’s also true that many negatively geared properties turn positive over time with increasing rents in the area. You can try to expedite this process by making improvements to your house and demanding a higher rental. This may include strategic kitchen and bathroom renovations or even improving the energy efficiency of the home, which can be an important consideration for environmentally-conscious tenants.