Gearing: Positive, negative and downright ugly
Article by Mozo
Aussies are addicted to negative gearing but it’s not the only property investment strategy that can reap big rewards and, sometimes, it can be the worst option.
Gearing, or borrowing to invest, can be a powerful wealth creation tool. It basically means you get to use someone else’s money – the lender’s – to buy more shares or a bigger property than you could afford if you could only use your own money. You have to be able to pay interest and eventually pay back all the money you borrow, but the main advantage is your profits should also be bigger.
Borrowing to invest can have an ugly underbelly. Just as you can make bigger profits, if things turn sour, you can also lose more money. In extreme circumstances, you can end up losing every cent of your own savings and still end up owing money to the lender.
Many investors may not realize that there is more than one gearing strategy available, particularly when investing in property. Generous tax concessions make negative gearing the ‘darling’ of many respectable investment advisers, along with many spruikers and sharks.
‘Positive gearing’ is talked about (and flogged) less often but it has excellent advantages. Mozo’s money experts look at the differences between positive and negative gearing and how can you avoid ‘gearing scams’ that could leave your financial dreams in tatters.
Negative gearing: good and bad
Negative gearing means the costs that come with owning an investment property, including loan interest, rates, repairs etc, are greater than the cash flow earned from rent. The advantage of this strategy is that, if you are in a higher income tax bracket, the investment-related loss can be offset against other taxable income, so you pay less tax.
The philosophy behind negative gearing is that you are sitting on an asset that is appreciating in value over time. Profits will come in the form of capital gains when the property is sold. Meanwhile, you can use the costs of your investment loan to reduce your overall taxable income but there won’t be any money flowing into your bank account from the property so it’s not an income –producing investment.
For this strategy to be successful, you’ll need to find a property with good capital growth potential. You’ll also need to have enough cash from other sources, like wages, to make loan repayments, especially if a tenant moves out and it takes a few months to find someone else to move in. If the house if vacant for weeks or months you won’t earn any income from rent but you still have to pay all the usual costs.
The dangers of negative gearing include coping with years when interest rates are high and property values don’t increase as rapidly as you’d like them to. It is possible to end up paying out more over the years that you are paying off the property than you actually get back when it is sold. Now that’s a double-negative!
Good news comes in the form of rental growth. Over time, as you can charge more rent, the rental income flowing from the property into your bank account can become greater than all the costs, so you end up with a cash flow positive investment or a positively geared property.
Every few years our politicians and social commentators debate whether or not the tax perks associated with negative gearing should be abolished so there is also a long-term political danger that the rules could change and the tax advantages disappear.
Positive gearing: good and bad
A positively geared property makes more income than you have to pay out in costs from day one. The rent paid by tenants is greater than your loan repayments and costs like rates and repairs. This is an income-generating venture and you still have the hope that the capital value of the property will increase over time so you will make a capital gain when you sell.
The downside is that because the property is cash flow positive, you’ll earn more income and pay more tax. However, all the experts, including ASIC, warn investors against purchasing property (or any investment) for the sole purpose of minimizing tax.
Reliable long-term tenants, and the prospect that the amount of rent you’ll be able to charge them will increase at least ahead of inflation, are the ingredients you’ll need to make sure positive gearing works to your advantage. Interest rates staying low for a long time also helps.
When gearing turns ugly
Scams relating to borrowing to invest are common. Real estate scammers sell negative gearing like it is some sort of government sanctioned scheme. They encourage unsuspecting investors to use the equity in their own homes to start borrowing to invest. They encourage people to borrow to invest several properties, all negatively geared.
Sometimes investors even fall for the idea of cashing in their super illegally, or setting up a self-managed super fund that’s not right for them, so they can increase the amount they are able to borrow.
Trying to pay off several negatively geared properties at the same time can only work if you are a very high income earner with secure and regular cash flow from a variety of other sources. No matter how good the returns look on those pretty computer-generated charts, consider how much stress you’d be under if one or more of the properties was vacant for more than a couple of days, let alone months!
Other dangers could include a change in your circumstances. What would happen if you were unable to work for months, or even years, due to illness or injury? How would you pay back the loans? How would you cope with higher interest rates or even a property crash?