finance property

The Difference Of Negative Gearing, Neutral Gearing And Positive Gearing?

Negative gearing, positive gearing and neutral gearing; you hear these phrases often, but I think many people don't understand what the terms mean. I will outline what precisely what those terms mean as well as briefly explaining why some investors choose to buy negatively geared properties.

For property investors, Australia's tax law can appear incredibly complex, but understanding negative, neutral and positive gearing is vital. How a property is geared makes a massive difference to an investors' bottom line, so choosing the best option is critical.

Let’s explain what gearing what gearing is: Gearing in regards to a rental property or other investment refers to the amount of borrowing and interest deductions attached to the investment.

When you borrow money to invest, it is called gearing, and it is very often linked to discussions regarding investment properties. Depending on the income earned from an investment, there are three types of gearing: positive, neutral and negative.

As per current Australian tax law, you may be able to claim the interest portion of your loan repayments and also some other costs as an expense, providing that the property is available to be rented. One of the critical advantages of negative gearing is that the loss associated with the property owner may be offset against other income earned, such as salary, reducing your taxable income and therefore the amount of tax payable.

In some situations, the savings gained through tax deductions can exceed the losses realised from the property – with the overall result being that the cost of owning the property is being funded by your tenant in the form of rents paid, but also by the Australian Tax Office in the form of tax savings, and by your other surplus cash flow, such as your savings and other forms of income.

With positively geared properties, the surplus income generated can be put to other uses and other investments or just set aside to meet any future increases in costs or loan repayments.

It is a well-established practice for higher taxpayers to seek out a negatively geared investment property to maximise their tax returns. At the same time, they also seek a hoped-for increase in the long-term capital growth of the property.

Property investors closer to retirement or in a lower income bracket may choose positively geared investments as they are keen to increase their income earning potential.

Gearing can help increase an investment's return but also can magnify losses, and so requires careful consideration and the seeking of professional advice before making decisions.

In this article, we explain exactly what positive gearing is. We will also explain what negative gearing, positive cash flow and neutral cash flow are.

There are many pros and cons to investing in different types of real estate. But first, you must understand the definitions of different types of investment properties first. All these terms relate to how a property affects your cash flow on an ongoing basis.

Definition Of Negative, Positive And Neutral Gearing

Put negative gearing means an investment asset incurs more extraordinary expenses than the income it generates, while positive gearing indicates the investments income is higher than its related costs. Neutral gearing is, of course, when payments and income are equal. If an investment asset is negatively geared, an investor can reduce his or her taxable revenue by the amount of the losses incurred while holding the support. The types of expenses that can be claimed to reduce income and thus, taxable income must be specifically related to the acquisition and maintenance of an income-producing asset. For property investors, the main deductions are typically loan interest, depreciation, council rates, managing agent fees, maintenance and strata fees if applicable.

Positive Gearing

Positive gearing is where the annual rental income from a property is higher than the annual loan repayments and costs. In this situation, you are making an extra income from your property; however, this income is taxable and hence needs to be declared at tax time.

Positive gearing can be very profitable for investors, especially where there are high rental yields, and fans of this type of investment argue that the profits made can then be used to help fund additional investment properties.

Positive gearing occurs when the gross income generated by the investment is more than the cost of owning and managing the acquisition, including interest charged on the borrowings (payments reducing the principal component of borrowings is not included as a cost). The investment generates a positive cash flow before and after taxation is taken into account.

Positive gearing (or only 'gearing') is where the gross income you get from your investment property (or any investment, for that matter) is greater than the total amount of the deductions/ expenses. Positive gearing creates a situation where you'll need to pay income tax on your net income.

With this type of property keep in mind that you will also have to pay capital gains tax should you decide to sell the property.

Let's say you own a house (it doesn't matter how much it cost). Every month it brings in $1,000 in rental income, and every month you pay $800 in property expenses. A positive property is one that generates an annual profit because the rental income exceeds the property's yearly holding costs. Tax will be payable on the profit but can be minimised by maximising your eligible deductions such as depreciation.

At the end of each month, you have $200 in cash leftover (before tax) and after-tax you will still have more than $100 leftover (maximum tax rate is 45% not including Medicare levy or surcharge).

Haberfield says a property is positively geared when the rental income exceeds the expenses which can be claimed, resulting in taxable income to the taxpayer.

Negative Gearing

If your property is negatively geared, then its rental income is less, then the costs needed to maintain and keep the property. Negatively geared properties are generally the first step for most investors, and they are attractive because of the huge tax benefits.

Negative gearing is a form of financial leverage where an investor borrows money to invest. Still, the gross income generated by the investment is less than the cost of owning and managing the investment, including interest charged on the borrowings. The investment generates negative cash flow.

Let's say you own a house (it doesn't matter how much it cost). Every month it brings in $1,000 in rental income (same as above example) BUT let's say this time it costs you $1,200/month in property expenses.

In this case, at the end of each month, you would have -$200. This means you would have to find $200 from somewhere else (probable income from your job) to pay for this 'debt'.

Assuming no depreciation (depreciation explained) before tax, you would have lost money ($200) and after-tax you would have lost money (~$200-$110 depending on your tax rate).

While many people go into property investing, thinking their investment will be an instant source of cash flow, this isn't always the case.

Depending on the net income earned from a property, an investment property can be positive, neutral or negatively geared.

In a situation where an investor is receiving a higher rental return than the outgoing expenses, the property will have positive cash flow, and the owner will pay tax on this income earned.

By contrast, a negatively geared property has a rental income which is less than the outgoing expenses, including deductible losses. Therefore, the property investor is making a cash loss on their investment.

This cash loss can be used to offset any income received, such as a salary, meaning that overall, an investor with a negatively geared property will be required to pay less tax to the ATO.

As such, this is essentially using the taxation system to help offset the loss from an investment property.

For many, this is a short-term solution until an investment property can start making positive cash flow.

However, this is a popular strategy for many Australian investors, and some choose to remain negatively geared as part of a longer-term plan. As with any choice relating to an investment property, investors need to weigh up the pros and cons of this approach, in line with their individual investing goals.

The losses incurred on negatively geared properties can be offset against other forms of income as a tax deduction, therefore reducing taxable income. Another benefit of negative gearing is that there is the potential to make long-term gains through capital appreciation. This is where the value of your property increases more enormous than the costs.

The term 'negative gearing' describes what happens when you borrow money to pay for an investment, and the value of the interest on your loan is more than the income you've received from your investment. To put it in property terms, an investment property is said to be 'negatively geared' when your annual rental income is less than the interest costs on your mortgage plus all of the expenses associated with your property (i.e. resulting in a net loss).

Most of the time, when you read or hear about negative gearing these days, it's related to investment properties. Australia's one of the few countries in which negative gearing losses from property investments are tax-deductible.

Over time though, many investors choose a negatively geared property with the hopes that it will eventually become neutral or positively geared.

Generally, if a property is negatively geared, it means the deductions which can be claimed for the property outweigh the rental income, so there is a tax loss from the property, Haberfield says.

 

Neutral Gearing

Neutral gearing is when the income from the property is exactly equal to the borrowing and maintenance costs. In this situation, the income is taxable, but the borrowing costs are tax-deductible.

Neutral gearing, as you've probably guessed, is when the expenses for and the income from an investment are equal. When this is the case, there's neither a tax advantage nor a disadvantage.

Neutral gearing is when the income earned from an investment property is the same as the total expenses, which may include mortgage repayments, maintenance costs, property management fees and other ongoing or one-off costs associated with owning an investment property.

"Neutral gearing means that the income and expenses are the same, so there is no effect on the taxpayers' income," she says.

When most people discuss neutral cash flow, they don't specify whether or not it is calculated before or after tax. It is very rare for a property to break even EXACTLY. However, many people will call a property "neutral" if the income or loss is considered insignificant. (eg. A profit of $7.85 on a property worth $500,000 would be considered insignificant and probably called a neutral cash flow property by most people.)

 

A neutral cash flow property means the property is making neither a profit nor a loss each year because the rental income balances out the loss. Hopefully, the property is generating capital gains, and it will likely become a positive cash flow property if rents rise and interest rates fall.

Neutral gearing is a safe option for investors as there are little to no costs to keep the property. However, gains can still be made from capital appreciation.

Remember, it is always a good idea to talk to an accountant or a financial advisor regarding the gearing strategy that is most suited to your financial situation. Neutral cashflow properties suit investors who are looking to have many properties in their portfolio. They are willing to sacrifice some capital growth in the knowledge that the properties pay for themselves in the initial stages, and when the mortgages are paid off, they are able to live off the rental income.

If this sounds like you, you should be looking for a property right now. With interest rates at 40-year lows, it has presented us with a once in a generation opportunity.

Why Negative Gear?

"The advantage of negative gearing is it creates a tax loss, which can be offset against a taxpayers' other income, to reduce taxable income and hence tax paid," Haberfield says.

"However, due to the high level of debt against the property, the disadvantage is that the cash received from the rent will not be enough to cover the expenses and any principal loan repayments, so the taxpayer will need to fund the difference," she adds.

Haberfield says investors generally buy negatively geared properties because of the tax perks.

"There are also some non-cash deductions that can be claimed for a rental property, such as depreciation on fixtures and fittings and also building write-off, which allows a taxpayer to claim 2.5% of the actual building costs of the property each year, that increase the tax loss, without increasing the cash outflows.

"Depending on how much can be claimed for these additional deductions, the taxpayer may be not having to fund too much of the tax loss out of their cash reserves. So, they can save on tax without reducing their cash flow," she says.

Why Positive Gear?

"With positive gearing, the advantage is the taxpayer is receiving more money they have to pay out, so there is positive cash flow.

However there will be additional tax to be paid on the profit," Haberfield explains.

"Also, depending on the principal repayments on any loans, there may still be a cash shortfall, although this will be less than for negative gearing."

 

Why Neutral Gear?

The beauty of owning neutral cashflow property, where the rent coming in is the same as the money going out, is that the property costs you nothing to own! In reality, as time progresses and your rents increase at a greater amount than your expenses, you end up with a property where your tenant pays all your expenses, and you have some money left over. This is termed positive cashflow.

If your goal is to own many properties, purchasing neutral (and positive), cashflow properties are the best way to achieve this. To purchase property that has a negative cash flow means that you have to dip into your own pocket to help pay the rental expenses. Your pockets are not bottomless pits so there is a limit on how much money you can put in to supplement the rent. (It is usually the bank that will place these limits).

In theory, you can buy an unlimited amount of neutral cashflow properties as it doesn't cost you anything. However, borrowing money from the bank is not only about cash flow. They are also looking at your equity position, which is how much you own compared to how much you owe.

Even though the cash flow for neutral cashflow properties looks good on paper, the bank also takes into account vacancies, increasing costs and unexpected expenditure, thus limiting your purchasing power. However, if you have a secure job and income and plenty of equity, you can buy many neutral cash flow properties.

Can a negative property turn positive, and vice versa?

As touched on above, a property that was originally negatively geared can turn positive if it's a long-term investment. Over time, rents will rise, interest rates may drop, or you may pay down some or all of the principal (thereby reducing or cutting your payments).

Eventually, the rental income will become equal to or greater than the costs of holding the property – turning it neutral or positive. This is often the long-term strategy of negative gears who see it as a retirement plan – an asset that will provide them with cash flow during retirement.

Unfortunately, the opposite is also true. A property that was originally positively geared can turn negative in the event of a rental market shift and interest rate rise. Both cases typically need to be quite extreme to put a property into the red – it's more likely that your profit will decrease rather than disappear. This, of course, is not ideal either.

Investors – whether positively or negatively geared – are encouraged to plan for these situations to minimise the impact if they are faced with one. With some simple preparation, i.e. ensuring you have emergency funds put away, you will be well-positioned to ride out tough market conditions.

Should I invest in negative and positive property?

Portfolio diversification is very important for risk reduction. Many investors find that a balance of negative and positive properties gives them exposure to a range of markets and won't leave them with a cash flow problem. Investing in well-located negative and high-returning positive properties is an ideal overall strategy for achieving the best of both worlds – growth and passive income.

 

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