So much fuss revolved around the issue of negative gearing during the 2016 and 2019 federal elections. A lot of folks thus had asked, what is negative gearing?
The Labour Party put a restriction on negative gearing amongst its signature platforms for policy changes in those past elections. But it eventually dumped this policy shift in 2021 ahead of the next federal polls.
That Australia is a nation of investors may be the reason for the party’s turnaround. Let’s dig deeper into the question “what is negative gearing?” —with its restriction threat lifted, some market opportunities for you may have been firmed up or opened.
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What is negative gearing?
Negative gearing is one of three tax scenarios that investors face when buying a rental property on borrowed money. The other two are neutral gearing and positive gearing, and we’ll look at how each of these three works.
Negative gearing is when the total cost of your rental property exceeds the yearly income it generates. Your ownership of this property creates a tax-deductible loss. You can typically offset this loss by other income, like your salary or wage, thus resulting in a tax saving.
Australian law allows the tax deduction on rental property loss as an incentive for investors to increase the rental housing supply. Some sectors, however, see negative gearing as a putdown on the growth of affordable housing, with investors favouring the development of rentals.
The Labour Party, before junking negative gearing restrictions from its policy platforms, advocated this view.
Many rental investors use negative gearing to cash in on the growth of the properties’ value over the long term. To derive this long-term benefit, rental investors must have a good grasp of their gearing ratio.
This ratio measures the debt proportion in the rental investors’ equity or capital, which changes over time after mortgage payments. The gearing ratio helps investors determine the long-term financial stability of their rental property.
Neutral gearing
If you’re in neutral gearing, your income from a rental investment property is just about equal to your total expenses. Ongoing and one-off costs including mortgage payments, maintenance costs, and property management fees are among these expenses.
It is obvious in the case of neutral gearing that you will neither enjoy a tax advantage nor a tax disadvantage. Breaking even exactly is rare in neutral gearing. However, investors will consider themselves in this territory if their loss or gain is insignificant or just loose change.
For example, an investor with a $9.50 loss/gain from a $550,000 rental property generally falls under neutral gearing.
Positive gearing
Investors are in positive gearing when the rental property they’re paying a mortgage on is earning money after all expenses are deducted. Because of the positive cash flow, the investors will of course have to pay the tax due on their profits.
Positive gearing, hence, is the ideal situation for rental investors. With their surplus income, they can trim down the size of their mortgage loan. In addition, they’re not only generating consistent income from their investment property.
They also stand to realise a handsome capital gain if the property is sold later. This gain can be substantial because of the strong growth of residential property prices in Australia.
Positive gearing is ultimately the best option for rental investors. However, it can be difficult to raise rents to a level allowing them to generate a steady income from their property. Residential Tenancies Act in Australia’s states and territories regulate rent increases.
Generally, rents can only be increased at intervals of once every six months. And the terms of rent increases have to be provided in landlord-tenant agreements.
How does negative gearing work?
Most investors appear in favour of the negative gearing tax strategy. Based on figures from the Australia Tax Office (ATO), 1.3 million of 2.2 million property investors were negatively geared.
These investors constitute nearly 60% of all Australia’s landlords. They seem to give more weight to the negative gearing’s benefits cited earlier on potential tax savings and capital growth. Sufficiently enough for them, these answer what is negative gearing all about.
Negative gearing also has the potential to open up a wider range of rental investment options to choose from. Investors can explore places with better prospects of attracting tenants.
Focusing on properties with positive cash flow limits investors’ choices to areas where the rental income tops expenses. Property prices are often higher in these areas, which don’t suit many investors’ appetites.
How to calculate negative gearing
Seasoned rental investors use a negative gearing calculator to estimate the potential tax benefits from a property purchase through a mortgage. The initial inputs which are needed for the calculation include the following:
- The purchase price of the rental investment property
- The total mortgage loan amount the investor needs
- The loan term or tenure of the mortgage loan
- The fixed interest rate that the mortgage loan carries
The investor will then do some pencil-pushing on the projected yearly rental return or rental income on the investment property. The annual salary and other taxable income of the rental investor will also be added factors to the negative gearing calculator.
After this, the investor will need to provide details of the projected annual cash expenses for the upkeep and management of the rental property. These cost items include the land tax, strata fees, council rates, and repairs and maintenance costs.
Using a negative gearing calculator
Typically, a rental property investor would look for an independent consultant when using a negative gearing calculator. This professional assistance can come from a tax specialist, mortgage broker, or financial adviser.
Professional advice is vital as a rental investor wrestle down what is negative gearing and the tax benefits it holds. Consultants can help the investor weigh factors like interest rates which can fluctuate throughout the term of a mortgage loan.
A mortgage broker’s advice, in particular, would be vital on the location of the rental property investment. This will help assess current and potential renting demand, which is crucial in projecting an annual rental income.
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