Positive vs. Negative Gearing: Which is Right for You?
Investing in property is a popular strategy among Australians looking to build wealth. One of the critical decisions property investors face is whether to adopt a positive or negative gearing strategy. Both have their unique advantages and disadvantages, and the right choice depends on your financial situation, investment goals, and risk tolerance. This article will delve into the concepts of positive and negative gearing, compare their benefits and drawbacks, and help you determine which strategy might be right for you.
What is Gearing?
In the context of property investment, gearing refers to borrowing money to purchase an investment property. The terms positive gearing and negative gearing describe the relationship between the income generated by the property and the expenses incurred in owning it.
Positive Gearing
Positive gearing occurs when the rental income from an investment property exceeds the expenses, including mortgage interest, maintenance costs, property management fees, and other associated costs. This results in a net profit before tax.
Example:
Bruce purchased an investment property for $485,000 and rents it out for $575 per week. His total expenses amount to $460 per week. Therefore, Bruce has a positive cash flow of $115 per week ($575 – $460).
Negative Gearing
Negative gearing, on the other hand, happens when the expenses of owning a property exceed the rental income it generates. This results in a net loss, which can be used to reduce taxable income.
Example:
Harry bought an investment property for $560,000 with a mortgage costing $25,800 annually in interest. His rental income is $23,400 per year, resulting in a loss of $2,400 ($23,400 – $25,800).
Benefits of Positive Gearing
Immediate Profit
- Cash Flow: Positive gearing provides immediate positive cash flow, which can be used to pay down the mortgage, save for another investment, or cover personal expenses.
Lower Risk
- Financial Stability: Since the property generates a profit, investors are less reliant on capital growth and can maintain financial stability even if property values stagnate or decline.
Easier to Manage
- Simpler Finances: Positive gearing simplifies financial management as investors do not need to cover shortfalls between rental income and expenses.
Drawbacks of Positive Gearing
Higher Tax
- Taxable Income: The profit generated from a positively geared property is added to the investor’s taxable income, potentially pushing them into a higher tax bracket.
Limited Capital Growth
- Location Constraints: Positively geared properties are often found in areas with lower capital growth potential, which can limit long-term investment returns.
Benefits of Negative Gearing
Tax Deductions
- Tax Benefits: Negative gearing allows investors to offset their property losses against other income, reducing their overall tax liability.
Potential for Capital Growth
- Long-Term Gains: Investors rely on the property’s value appreciating over time to achieve significant capital gains, which can offset the initial losses.
Portfolio Diversification
- Investment Leverage: Negative gearing enables investors to control more valuable assets with a smaller initial investment, potentially leading to greater long-term gains.
Drawbacks of Negative Gearing
Cash Flow Challenges
- Financial Strain: Investors must cover the shortfall between rental income and expenses, which can strain personal finances, especially if interest rates rise.
Market Dependence
- Risk of Loss: The success of negative gearing heavily depends on the property market’s performance. If property values stagnate or decline, investors may not realize the expected capital gains.
Regulatory Risks
- Policy Changes: Government policies and tax laws can change, potentially affecting the benefits of negative gearing. Investors must stay informed about any regulatory changes.
Which Strategy is Right for You?
Choosing between positive and negative gearing depends on various factors, including your financial situation, investment goals, and risk tolerance.
Considerations for Positive Gearing
- Stable Income: If you prefer a steady income stream and lower financial risk, positive gearing might be more suitable.
- Tax Position: Consider the impact on your taxable income and whether you are comfortable with potentially higher taxes.
Considerations for Negative Gearing
- Long-Term Growth: If you are focused on long-term capital gains and can handle short-term financial losses, negative gearing could be advantageous.
- Tax Benefits: Evaluate your current tax situation and how negative gearing might reduce your taxable income.
Both positive and negative gearing have their merits and challenges. Positive gearing offers immediate cash flow and financial stability, while negative gearing provides tax benefits and the potential for significant long-term capital gains. The right strategy for you will depend on your financial goals, risk tolerance, and current financial situation. Consulting with a financial advisor or tax professional can help you make an informed decision that aligns with your overall investment strategy.