Negative Gearing – Is It A Good Strategy?

Negative Gearing In Australia – Is It A Good Strategy?

Have you ever wondered why so many investors are willingly buying assets that lose money each year? It might sound counterintuitive, but for many, negative gearing is a strategy providing significant financial rewards.

Whether it’s property or shares, negative gearing has sparked debates for decades, praised for its tax benefits but criticised for its risks. So, is it worth it?

In this article, we break down how negative gearing works, its advantages, drawbacks, and who it might suit best. By the end, you’ll know whether this controversial investment strategy deserves a place in your financial plan.

What is Negative Gearing?

Negative gearing occurs when the costs of owning an investment, within the context of  direct property this could include mortgage interest, maintenance, insurance, and depreciation – exceed the income generated from rent. Investors can offset this loss against their taxable income, potentially reducing their overall tax liability.

For instance:

• You purchase an investment property with an annual rental income of $20,000.
• Your expenses, including interest repayments, total $25,000.
• You incur a $5,000 annual loss, which can be deducted from your taxable income.

While negative gearing is often associated with property, it can also apply to other investments such as shares or managed funds. For non-property investments, the same principle applies.  When the costs of holding the asset (e.g., interest on borrowed funds) exceed the income generated (e.g. dividends), the loss can be used to offset taxable income.

For example:

• You borrow to purchase shares that generate $5,000 in annual dividends.
• Your interest payments and associated costs amount to $8,000.
• You incur a $3,000 annual loss, which can be claimed against your taxable income.

This opens up opportunities for investors to diversify their portfolios while still benefiting from negative gearing tax advantages.

The Pros of Negative Gearing

1 – Tax Benefits

The most touted advantage of negative gearing is the ability to claim investment losses as deductions on your taxable income. For individuals in higher tax brackets, this can result in substantial tax savings.

For example, if you’re in the 37% tax bracket, a $5,000 loss would reduce your tax bill by $1,850 (37% of $5,000).

2 – Capital Growth Potential

Negative gearing is often part of a long-term investment strategy, where investors accept short-term losses in the hope that the property’s value or investment assets will appreciate over time. A well-selected property or share portfolio can result in significant capital gains that outweigh the initial losses.

Pro Tip: To maximise capital growth, focus on properties in areas with strong demand, infrastructure projects, and economic growth, or shares with strong long-term growth potential.

3 – Leverage & Wealth Creation

Negative gearing allows investors to use borrowed money (leverage) to acquire assets they might not be able to afford outright. Over time, as the property appreciates or as the value of non-property investments increases, investors build equity and wealth.

4 – Rental Income & Dividend Growth

While a property may initially operate at a loss, rental income typically increases over time with inflation. Similarly, dividends from shares can increase as companies grow, potentially turning a negatively geared portfolio into a profitable one over time.

5 – Diversification Of Investment Portfolio

For investors looking to diversify their assets, negative gearing can apply to a range of investments beyond property, including shares, managed funds, and other income-generating assets. This enables investors to spread risk while still taking advantage of tax deductions.

The Cons of Negative Gearing

1- Cash Flow Pressure

The most significant drawback of negative gearing is the cash flow strain it can impose. Since the investment operates at a loss, you must cover the shortfall out of pocket. This can create financial stress, especially if unexpected expenses arise or interest rates increase.

2 – Interest Rate Risk

Negative gearing is heavily reliant on borrowing, which means you are exposed to fluctuations in interest rates. A rise in interest rates can increase loan repayments, exacerbating your losses and affecting your ability to hold onto the investment.

For example:

• A 2% increase in interest on a $500,000 loan equates to an extra $10,000 per year in repayments.

3 – Market Volatility

Whether it’s property or shares, markets can be unpredictable. Economic downturns, oversupply of housing, or falling share prices can negatively impact asset values and income returns.

4 – No Guarantee Of Capital Growth

If the property does not increase in value or if share prices stagnate, the investor may end up with ongoing losses and limited prospects for recouping those losses.

5 – Dependence On Tax Policy

The benefits of negative gearing are subject to government policy. There is always a risk that future governments may reduce or eliminate negative gearing incentives, impacting investors’ financial strategies.

6 – Opportunity Cost

By committing significant funds to a negatively geared property or investment, you may miss out on other opportunities with better short-term returns or lower risk.

 Who Benefits Most From Negative Gearing?

Negative gearing tends to favour investors with:

• High taxable incomes: The tax benefits are more pronounced for individuals in higher tax brackets.
• Long-term investment horizons: Investors willing to accept short-term losses for potential long-term gains.
• Sufficient cash flow: Those with the financial capacity to cover property or investment losses without jeopardising their lifestyle.

It may not be suitable for individuals with limited income, low risk tolerance, or those who require immediate returns from their investments.

How To Minimise The Risks Of Negative Gearing

While negative gearing can be an effective strategy, effectively managing its risks will significantly increase your chances of success. Below are a few elements worth considering:

1. Choose The Right Property Or Asset: Focus on properties in high-demand areas with solid growth potential, or shares with a proven track record of long-term performance.
2. Manage Your Cash Flow: Ensure you have sufficient income or savings to cover property or investment losses, especially during periods of market volatility or rising interest rates.
3. Fix Your Loan Interest Rates: Consider fixing part or all of your loan to protect against rising interest rates and manage cash flow predictability.
4. Diversify Your Investments: Don’t put all your eggs in one basket. Balance your property investment with shares or other assets to spread risk and improve overall portfolio performance.
5. Consult A Financial Planner: Work with an experienced financial advisor to tailor an investment strategy that aligns with your financial goals and risk tolerance.

Is Negative Gearing Right For You?

Negative gearing is a double-edged sword. While it offers tax benefits and the potential for long-term capital gains, it comes with significant risks and cash flow demands. Before pursuing this strategy, it’s essential to assess your financial situation, risk appetite, and investment goals.

At Manly Financial Services, we specialise in helping clients make informed investment decisions. Whether you’re considering negative gearing for property or non-property investments, our team of qualified financial planners can guide you through the process to ensure your investment aligns with your long-term objectives.

Conclusion

Negative gearing remains a popular strategy among Australian investors, but it’s not for everyone. Understanding the pros and cons for both property and non-property investments is crucial to determining if it aligns with your financial goals. If you’re ready to take the next step, speak to a financial planner who can tailor a strategy to your needs.

Important Disclaimer: The information provided in this article is general in nature and does not constitute financial advice. Please consult with a qualified financial advisor to discuss your individual circumstances.

References:
ATO: Rental Properties and Deductions
Reserve Bank of Australia – Housing and Interest Rates