Negative gearing is a strategy used by people to grow the value of their investment while keeping their tax as low as possible. Investors use negative gearing because the interest repayments on loans are typically tax deductible against their personal income.
For example, Jenny owns a successful cafe and pays tax at a rate of 45%. She wants to make long term investments but also wants to keep her tax as low as possible.
Jenny decides to buy a $1 million investment property in Sydney, hoping that can sell it in five years for a large profit.
Jenny buys the property using an interest-only bank loan, which charges 5% interest each year.
Jenny’s new investment property earns yearly rent of $40,000, or 4%.
So in a year, Jenny receives only 4% in rent but pays 5% in interest on her loan. Therefore, Jenny is out of pocket 1% from her investment.
She can use this negative 1% as a tax deduction against her personal income, which means she might pay less tax that year.
So how does Jenny make money from her investment?
In addition to the tax savings, people who use negative gearing expect the value of their investment to increase over time. So when they sell the investment, they make a profit.
Is negative gearing risky?
Using a loan to buy an investment like property and shares can be risky. That’s because the price of the investment can rise and fall — sometimes rapidly. What’s more, the income received from the investment might not always cover the loan repayments, leaving the owner to foot the bill from their own pocket.
Other risks include:
- Interest rate risk: if interest rates rise, the loan repayments might also increase.
- Income/salary risk: if the owner of the investment loses their job, negative gearing may put more pressure on living expenses.
- Legal risk: negative gearing — especially for the purposes of buying Australian property — is frequently cited in the news and by some politicians as one of the reasons for high house prices. If the government introduced new tax laws, negative gearing may not be a worthwhile strategy for some investors.
Does negative gearing make house’s more expensive?
Because negative gearing is so effective, people can buy multiple investment properties and keep their tax very low. This has led many people and some experts to believe that negative gearing is one of the reasons Australian house prices have risen so quickly.
Is the interest on ALL loans tax deductible?
No. It cannot be assumed that all negatively geared investments will be able to claim a tax deduction for interest repayments.
You should consult a licensed and trustworthy taxation professional before making a decision to use negative gearing.Did you know Rask Education offers investing, budgeting, tax and finance courses? Here are the three most popular: Absolutely no credit card or payment information required -- all you need is an email address!