Investing in property can be a great way to build wealth, but not all strategies are created equal. One of the most popular is negative gearing, which has been causing a lot of debate.
While it might sound good to some investors, negative gearing has some big downsides that are worth understanding. Since a lot of us know why negative gearing is good, why is negative gearing bad?
What is Gearing in Property Investment?
Before we get into why negative gearing is bad, let’s define what gearing means.
In property investment, gearing means borrowing money to buy an asset, like a rental property.
Whether you’re positively, negatively, or neutrally geared depends on the rental income versus your expenses, including interest payments and maintenance costs.
- Positive Gearing: Your rental income exceeds your expenses, you make a profit. Learn more about positive gearing.
- Negative Gearing: Your rental income is less than your expenses, you make a loss.
Note: Read our guide to find out about negative gearing changes. - Neutral Gearing: Your rental income equals your expenses, you break even.
The Attraction of Negative Gearing
At first glance, negative gearing seems good. If your property is negatively geared, you can offset your losses against your taxable income and reduce your tax bill.
For example, if you earn $90,000 a year and your property leaves you $5,000 out of pocket, you might deduct this from your taxable income and bring it down to $85,000.
But this short-term tax relief can lead to long-term financial strain. While the tax deductions are helpful, they shouldn’t be the reason you choose this investment strategy.
The Hidden Costs of Negative Gearing
One of the big downsides of negative gearing is you can get a big capital gains tax bill when you sell the property.
Even though capital gains tax is halved for assets held for more than 12 months, the amount can still be big, and constantly covering shortfalls out of pocket can be financially straining.
Plus, relying on property value appreciation to offset your losses is a risk. Property markets can be volatile and there’s no guarantee your property will increase in value as expected.
Check out our property investing guide for more on this.
The Downsides of Negative Gearing
According to Pete Wargent, Co-Founder of Allen Wargent Property Buyers, negative gearing has been a popular and successful way for investors to grow wealth over the long-term in Australia.
However, there are significant downsides that investors need to be aware of:
“With many 2% fixed rate mortgages resetting to 6.5% mortgages over the past year, some investors are finding out the downsides of negative gearing, whereby the cashflow drain can become painfully acute.
Generally speaking, established properties in Australia might generate a gross yield of 4 to 5% for units, and 3 to 4% for houses, before other holding costs, although the figures can vary by capital city (yields tend to be lowest for houses in Melbourne, for example) or region (some regions can see yields of above 5% on offer).
Pete Wargent, Co-Founder, Allen Wargent Property Buyers
Eyeballing these figures immediately tell you that a leveraged investor paying a mortgage rate of 6.5% may be facing a significantly negative cashflow in the early years of the investment.”
As mentioned, negative gearing may have some tax benefits, but the downsides often outweigh these. Here are some of the reasons why negative gearing can be bad:
1. Ongoing Financial Strain
With a negatively geared property, you’re losing money every year because your rental income doesn’t cover your expenses.
So you’ll need to dip into your pocket to cover the shortfall. Over time, this can add up to a big number and put constant pressure on your personal finances.
2. High-Risk Strategy
Negative gearing relies on the assumption property owners make that the property will increase in value over time.
But the property market can be unpredictable. If property values stagnate or go down, you could find yourself with a property that’s not only losing money but not gaining enough value to justify the losses.
3. Capital Gains Tax
When you sell your negatively geared property, you may get a big capital gains tax bill. While the tax is reduced for assets held for more than a year, it can still be a big number and wipe out a big chunk of your profit.
4. Limited Cash Flow
Because you’re constantly covering a shortfall, negative gearing can limit your cash flow. This can make it harder to manage other financial commitments or invest in new opportunities.
“If the property does not increase in value as you had anticipated, or interest rates rise, then you will be at an income loss for longer periods of time. If you don’t have enough cash flow, this method of investing will drain you financially.”
Paul Corazza, Director of Independent Property Group
5. Tax Benefits Are Uncertain
Tax laws can change, and relying on current benefits may not be a long-term strategy. Future governments could change or remove tax deductions for negatively geared properties and leave you in a financial bind.
| Aspect | Negative Gearing | Positive Gearing |
|---|---|---|
| Cash Flow | Negative | Positive |
| Tax Benefits | Yes, but temporary | Yes, but you pay tax on income |
| Risk Level | High | Lower |
| Capital Gains Tax | High | Lower |
Negative Gearing as an Investor
While negative gearing has its place for some investors, it’s important to look beyond the short-term tax benefits.
For many, a positively geared two-property portfolio, where rental income exceeds expenses, might be a more sustainable and lower-risk investment strategy. Find positively geared properties here.
The Bigger Picture
You need to consider your overall investment goals. Are you looking for regular income, or are you betting on future property value increases? Make sure your strategy matches your financial goals and risk tolerance.
Talk to a Financial Advisor
Given the complexity and risk of negative gearing, it’s best to talk to a financial adviser or accountant. They can give you personal advice and help you understand the long-term implications of your investment strategy.
Case Studies: Negative Gearing Fails
To see the pitfalls of negative gearing in action, let’s look at a few real-life scenarios.
Case Study 1: The Market Downturn
John bought an investment property in Sydney, expecting the value to increase significantly over time. He borrowed heavily and got a negatively geared property. For the first few years, everything went to plan. He offset his losses against his taxable income and reduced his annual tax bill.
But the market turned down. Property values in John’s area dropped and his property was now worth less than what he paid for it.
He was still covering the shortfall between his rental income and expenses, and his finances were getting strained. When John finally sold the property, the capital gains tax wiped out most of his profit, leaving him with a big loss.
Case Study 2: Cash Flow Crisis
Emily invested in a negatively geared property, expecting the tax benefits to make it a good investment. She managed the cash flow shortfall by using her savings. But unexpected expenses, such as major repairs and rising interest rates, increased her out-of-pocket costs.
Emily’s cash flow was limited, and she couldn’t keep up with the expenses of the property and her other financial commitments.
The constant need to cover the shortfall was putting pressure on her budget, and she ended up selling the property earlier than planned. The capital gains tax and selling costs wiped out most of her returns, and the investment wasn’t as profitable as she thought.
Case Study 3: Tax Law Change
Michael invested tax savings in a negatively geared property based on the current tax laws that allowed him to offset his losses against his taxable income. It worked for several years, reduced his tax, and made the investment look good.
But then the government changed the tax laws and removed the tax benefits for negatively geared investment properties.
Michael’s plan was heavily reliant on those benefits, and when they were taken away, he was left without the tax relief he expected.
The loss of that benefit made the property too expensive to hold, and Michael had to re-evaluate his strategy and sell the property at a loss.
Conclusion
Negative gearing can give you short-term tax benefits, but you need to understand the long-term risks and financial strain. Some may find it useful in certain situations, but it relies on good market conditions and stable tax laws, which can change overnight.
Investors should consider their financial goals, risk tolerance, and market conditions before using negative gearing as a strategy for capital growth.
For many, positive gearing, where rental income exceeds expenses, might be a more stable and less risky way to build wealth through property investment.
For more information on investment property, explore our guide to property investing.
For those looking to explore housing options, you can find real estate for sale that might offer more sustainable and profitable opportunities.
FAQ’s on ‘Why is Negative Gearing Bad?’
What is negative gearing?
Negative gearing is when the expenses of owning a rental property exceed the income it generates, and you get a taxable loss. This loss can be offset against other income such as wages and reduce your overall tax.
Is it better to be positively or negatively geared?
Positive gearing gives you immediate extra income and higher tax, but negative gearing gives you tax deductions through losses and potentially lower tax. It depends on your individual financial strategy and expectations of property value growth.
Is negative gearing good?
Negative gearing is good as you can deduct the net rental losses against other income and reduce taxable income and tax. This is done with the expectation of future property value growth exceeding the losses.
What are the downsides of gearing?
High gearing ratios can increase the cost of debt as higher-risk borrowers pay higher interest rates. This can increase borrowing costs, reduce profitability, and deter investments.
Remember, for personalized advice, always seek independent legal and consult a financial adviser. This ensures you make well-informed decisions that align with your financial goals and circumstances.
