For many years, negative gearing in Australia has been a contentious topic for lawmakers. It’s also been a major investment strategy for different types of investors. There may be several reasons an investor would want to invest in a negatively geared property.
Mainly, the tax break a negatively geared property offers is what attracts most investors. However, lawmakers have frequently opposed the current tax system, particularly the practice of investing in negatively geared properties. So there’s some level of uncertainty as well.
To understand this investment strategy better, you need to know the ins and outs of it. This article dives into negative gearing, its benefits, drawbacks, and analyses whether it’s still a good strategy for property investment in the coming year.
What is Negative Gearing?
Although negative gearing isn’t part of the official tax jargon, it’s come to describe a common investment situation, especially in the real estate world.
An investment that yields lower income than the expenses is termed negatively geared. In the context of real estate, a property that generates lower rental income as compared with the expenses or interest payments (mortgage) is said to be negatively geared.
In contrast, a positively geared property is one that produces higher income than the costs or interest on it.
Negatively geared properties are essentially investments incurring losses, making them eligible for tax deductions. The losses from such a property can be deducted against income from other sources, such as salary or other investments. This is called negative gearing.
It’s based on the general premise in the Australian taxation system that accounts for any expenses or losses in generating income. So income is eligible for taxes when adjusted for expenses and losses.
What Are the Advantages of Negative Gearing?
Negative gearing has emerged as a property investment strategy even though it can be applied to other asset classes. In other words, investors deliberately invest in properties that don’t have a high-income potential, and the costs to pay for the property and maintain it may exceed any income. So why do that? Here’s why:
Many investors buy properties that won’t yield profits for a few years in hopes that they will benefit from higher capital gains in the wake of a property boom.
Many investors also flip negatively geared properties to sell them in the future and walk away with higher profits.
The more attractive advantage of negative gearing is the tax advantage. The losses incurred from such property investment can be used as deductions for personal income, even from varied sources. This has helped high-income individuals to reduce their taxable income by investing in negatively geared properties.
Of course, the exact tax benefit may vary significantly based on losses from the property and overall income.
Drawbacks of Negative Gearing
Depending on your income, the tax deductions from a negatively geared property may or may not make a major dent in the actual tax you pay.
More importantly, such a property doesn’t have much cash flow or profit, so it’s not a suitable investment strategy for short-term returns.
Moreover, even in the long run, if you’re hoping to benefit from larger capital gains, there’s no guarantee that the property will sell for a much higher price, as the prices highly depend on the market.
Who Needs Negative Gearing?
As an investment strategy, negative gearing can be beneficial for individuals who have invested in low-income-generating properties to sell them at a higher price in the future. The tax breaks help offset the costs they have to bear while they hold onto the property.
That said, negative gearing has become more popular with high-income individuals and investors who take advantage of the tax deductions that come with such properties. They have other consistent and stable income sources, and the tax breaks help reduce their overall taxable income.
So this has also become a tax reduction strategy for investors with other high-yielding investments, including real estate.
Proposed Changes to Negative Gearing Tax Breaks and Their Potential Impact
Politicians and policymakers have proposed changes to the tax deductions offered on negatively geared properties over the years. The Labour Party proposed limiting such tax breaks to new properties only in 2016 and then again in 2019.
As many investors have used this tax deduction scheme to reduce their taxable income, the Labour Party proposed changing the law to limit such tax cuts. However, experts like Zaki Ameer of DDP Property say that such proposals would just benefit the rich and discourage mum and dad investors from buying properties within their means to create retirement income and wealth for themselves.
Such changes in the tax framework would have sent the market into panic mode. More importantly, property owners would then have to raise rents to generate income or, at the very least, meet the expenses. That, in turn, would increase the rents in major property markets and increase housing unaffordability for poor families.
Fortunately, such changes have failed to materialize, and investors will continue to benefit from tax deductions for negatively geared property investments.
Is Negative Gearing Still a Good Investment Strategy?
Despite the proposed changes by politicians to curb the practice of negative gearing, it remains a popular investment strategy for all investors.
For high-income investors, it’s an effective way to reduce taxable income. However, for most investors of such properties, including small investors, it’s a safety net to ensure that their losses are compensated for through tax deductions.
For those in the long haul, holding on to properties for capital gains when another real estate boom occurs, negatively geared properties are a viable investment strategy. For starters, such properties are typically cheaper to acquire, so even those with smaller capital can buy them.
While the tax cuts will continue for the foreseeable future, it’s best to consult a real estate investment expert to determine whether negative gearing aligns with your needs and future goals.
If you have other high-income-yielding properties or assets, a negative gearing strategy can reduce your taxable income.
The reality is that such tax deductions are crucial for mum and dad investors who may not have money to buy new properties. Even though they benefit the smaller high income portion of the population, it’s more beneficial for smaller investors who can buy loss-bearing property in hopes of turning capital gains in the long run.