Property investment is often described as both one of the simplest and most complex ways to build wealth.
Simple because if you apply a few well proven fundamentals, it’s possible to build a portfolio that’s reasonably easy to maintain and can grow over the long term to be a formidable cache of prosperity.
Complex because if you dig down into the nuances of finance arrangements, tax law, tenancy legislation and databanks, you end up in a world full of its own rules, regulations, and language.
And one of the concepts that catches up investors all the time is negative gearing.
It’s a term that’s loosely thrown around at a barbeque by investors wanting to start a political debate.
But few people actually understand what negative gearing is. Worse yet, negative gearing has been responsible for some fairly sizeable losses in the property investment space.
Here’s my rundown on negative gearing, and why I believe anyone who adopts it as part of their investment strategy needs to tread carefully.
What is negative gearing?
In its simplest form, negative gearing is available where the cost of owning and operating a investment property exceeds the return you make from it in rental income.
Of course, that seems counterintuitive. Why own an asset if it’s losing you money each year? Well, negative gearing allows the investor to deduct these losses from their annual taxable income, helping boost their returns and offset the property running costs.
And while the asset is losing money in terms of its net cashflow, it’s still expected to increase in capital value which is where the most substantial growth in wealth is generated. So long as you’re gaining more in capital growth than you are losing in negative cashflow, you come out ahead.
Let’s give a very simple example which looks purely at the loss generated by interest on a loan.
Say you buy an investment property for $600,000 and borrow 90% of the value to purchase it at an interest rate of 5%.
Your loan is therefore $540,000 and your annual interest bill is $27,000.
If you rent out the property for $450 per week, your annual rental income is $23,400.
This means you get to deduct $3600 off your taxable income each year purely due to bank interest. Depending on your income that can substantially boost your return.
Now let’s assume the property you purchased increases in value by 8% in year one to $648,000.
So, you’ve made $48,000 in capital gains while reducing your taxable income by $3600. Things are looking good.
Negative gearing has been viewed as a winning political strategy too. It’s designed to encourage investors into the housing market, thus increasing the supply of rental property which should, in turn, make rents more affordable.
Negative gearing dangers
While this might sound good, for negative gearing to work you must have the right set of conditions.
Firstly, you must purchase an appropriate asset for a reasonable price. Overpaying for a property will set you behind immediately. Worse still if you buy real estate that doesn’t go up in value enough to offset the loss from negative gearing. This equation has you losing money at a rate of knots.
Secondly, your annual taxable income must be substantial enough to cover ongoing cashflow losses due to loan servicing and maintenance of your property. If you are a low-income earner on the lowest marginal tax rate, negative gearing rarely delivers enough benefit for the risk of owning an investment. In addition, if interest rates rise quickly or there’s unexpected and expensive maintenance required for the property, you could face a challenging financial situation.
Beware the scam
Here is the other huge risk around negative gearing.
It has been used for decades by marketeering scammers to sell substandard investment properties to unsuspecting buyers.
If you find yourself in an ‘investment seminar’ with dozens of others being sold the benefits of negative gearing via a whiteboard and well-rehearsed salesman’s script, be very wary.
Scurrilous types will collect huge commissions from developers and builders for selling their overpriced property in poor locations to eager buyers. These unfortunate purchasers will pay too much for the investment which has the wrong fundamentals for capital growth, thus removing any benefit from the negative gearing strategy.
I’m not saying negative gearing isn’t a legitimate way to boost your investment portfolio. Managing tax is always key when considering your overall financial position.
But, please, make sure you understand what negative gearing entails for you personally before implementing it.
The best way to ensure you don’t get hurt via negative gearing is to have independent professionals on your side. This includes an accountant who understands your personal finances intimately. Also, an investment advisor without any vested interest in property sales is a terrific source of guidance.
Finally, you should rely on an experienced, independent property buyer who can help you unearth property assets that will fit your specific criteria. Seek only buyers’ agents who are paid directly by you – the client – and can demonstrate their unbiased specialist knowledge.