Negative vs Positive Gearing

Cashflow vs tax benefits

For investors who prioritize holding properties for the long term and achieving targeted capital growth, understanding cash flow is paramount.

Positive gearing is a strategy where the rental income from an investment property exceeds the interest on any borrowing. In contrast, negative gearing refers to when the rental income does not cover the interest costs and other associated property expenses.

While positive gearing can provide immediate cash flow, it may also result in higher tax payments as all rental income is considered taxable. On the other hand, negative gearing can generate tax deductions and potentially reduce tax payments while relying on future capital growth for profitability.

What is positive gearing and how does it work?

In simple terms, a positively geared property is one in which your rental income exceeds your expenses (such as mortgage repayments, repairs, strata fees, and council rates). This results in a positive cash flow before tax.

Investors choose positive gearing if they are looking for regular cash flow from their investment property. Additionally, positive gearing may provide a buffer against any unexpected expenses that may arise.

Advantages of Positive Gearing

Cash in Hand
Having a property fully covered by rental income means that you immediately begin generating positive cash flow.

Profit without relying on capital growth
Positive cash flow means immediate income from your investment, as opposed to relying on property prices to increase to make a profit.

Increased purchasing power
As a result of having a better cash flow, you can potentially use this to your advantage by investing in additional properties or paying down an existing mortgage on your principal place of residence.

Taxable income

Income generated from a positively geared investment is counted as extra income and therefore will be taxable.

The need for a unique approach

As per the ATO, only 40% of property investors in Australia have a neutral or positively geared investment property. Innovative strategies are occasionally necessary to enhance a positively geared property’s appeal in the market.

These strategies often involve actively renovating or adding value to existing properties. Alternatively, investing in properties with high rental yields (e.g., 5.5%) while interest rates are low is even better. Such positively geared properties with strong rental yields are commonly found in regional locations. However, it is important to note that these investments usually experience lower capital growth. In certain pockets of capital cities, there are strong opportunities for positively geared properties. It is just a matter of knowing where to look!

Positive Gearing over Time

Quality properties in prime locations can experience growth in rental rates over time. This means that what may have started as a neutral cash flow investment can quickly turn into a positively geared one, providing additional income and potential capital growth in the long term.

What is negative gearing?

As you might expect, negative gearing is the opposite of positive gearing. In negative gearing, the rental income received from the property is less than the sum of the outgoing costs, which includes expenses like mortgage interest, property management fees, and maintenance costs. So why would investors choose to seemingly lose money through negative gearing? Well, one reason is that you may be able to offset the losses against other taxable income, which can result in potential tax benefits. Additionally, some investors may see negative gearing as a long-term strategy, hoping that property value appreciation and future rental income increases will eventually outweigh the initial losses incurred.

Paper deductions vs out-of-pocket costs – understanding tax depreciation

The conversation around gearing tends to go hand in hand with tax or tax benefits – as tax savings or tax increases can impact your cash flow over the year.

What are paper deductions?

Paper deductions refer to the amount of depreciation that an investor can claim on their investment property. This includes building depreciation, fixtures and fittings, and other assets within the property. These claims are calculated based on an estimate of the property’s decline in value over time.

What are out-of-pocket costs?

Out-of-pocket costs refer to the actual expenses incurred by an investor, such as mortgage payments, insurance, maintenance, and repairs. These expenses can be claimed as tax deductions against any income earned from the investment property.

Owners of investment properties are eligible to claim tax deductions for a number of expenses involved in holding a property. Most investors are aware of some of the deductions they are entitled to claim such as their property manager’s fees, council rates, and any repairs and maintenance costs. However, often investors are unaware of property depreciation, which for new properties in particular, can have a big impact on cash flow.

Why is understanding tax depreciation important?

Understanding tax depreciation is vital because it can significantly affect your cash flow as an investor. By claiming the maximum amount of deductions, investors can reduce their taxable income and potentially increase their tax refund or decrease the amount of tax they owe.

Additionally, by accurately claiming tax depreciation, investors are able to better forecast their cash flow and make informed decisions about their investment strategies. This can also help investors maximize their return on investment and ultimately increase the overall profitability of their property portfolio.

How is tax depreciation calculated?

Tax depreciation is calculated by a qualified quantity surveyor, who will conduct an inspection of the property to identify all depreciable assets. These include both structural and non-structural items such as carpets, appliances, and even landscaping features. The quantity surveyor will then use the appropriate depreciation methods to calculate the depreciable value of each asset, taking into account factors such as the age and condition of the property.

What are some commonly overlooked deductions?

Aside from property depreciation, several other expenses can be claimed as tax deductions but are often overlooked by investors. These include fees paid to property managers, mortgage interest, insurance premiums, and even travel expenses related to managing the property.

Investors need to keep detailed records of all expenses related to their investment property to accurately claim these deductions and minimise their taxable income. Consulting with a tax professional or accountant can also help ensure that all eligible deductions are claimed.

Is negative gearing with positive cash flow possible?

A common misconception with many investors is the idea that a negatively geared investment property always means negative cash flow. However, the following simple example illustrates that this is not always the case.

Let’s say that last year John purchased an investment property – a new apartment – for $600,000, generating a rental income of $600 per week. He made a 20% down payment of $120,000 and obtained an interest-only loan at a rate of 5.5%.

At the same time, Anna acquired an investment property – a second-hand apartment – also priced at $600,000, with a rental income of $650 per week. She made a 20% down payment of $120,000 and secured a loan at the same 5.5% interest rate.

Annual Cash Flow

As shown in the example above, John’s investment property earning $600/week from rent is negatively geared, meaning his investment requires an additional $1,000 to hold each year. On the contrary, Anna’s property is positively geared with an increased rent of $650/week compared to John, providing her with a positive cash flow of $1,600.

If we add depreciation deductions into the mix, John’s situation changes. With John’s new $600,000 apartment, the property depreciation amount for the first year is $18,000. This “loss” from depreciation plus the $1,000 in negative cash flow equates to $19,000 that can be deducted from his taxable income.

Depreciation Tax Deductions

Compared to Anna who has to pay additional tax as a result of her positive gearing, John’s negative gearing and tax depreciation brings his taxable income down from $70,000 (-$19,000) to $51,000. As a result, John’s tax payable for the year is reduced from $14,616 to $7,826, saving $6,790.

This essentially puts John ahead by $5,790 for the year in positive cash flow despite his investment being negatively geared. Even when compared to Anna’s positively geared investment, John is earning $4,742 more than Anna’s investment which does not take advantage of depreciation.

While this example is simplistic, it highlights the crucial importance of carefully considering your options before investing in property. Both negatively geared and positively geared investments have their advantages and disadvantages, and it is up to the individual investor to determine which strategy suits their financial goals.

Our property investment strategists can assist in tailoring a strategy to align with your goals and circumstances. They can also connect you with finance professionals who can help minimise your short-term tax obligations while building a portfolio of high-quality assets over the long term. Begin by booking a free appointment using the button below.

This article is intended to provide general information only, current at the time of first publication. It does not constitute any financial advice, offer, contract or inducement to buy. Investors are expressly recommended to do their own due diligence in relation to any investment decision they make and seek independent financial advice.