Positive vs. Negative Gearing: Which Strategy Suits Your Goals?
Investing in property is a popular strategy for wealth building in Australia. One of the critical decisions property investors face is whether to pursue a positive or negative gearing strategy. Both approaches have their own sets of advantages and disadvantages, and the right choice depends on your financial goals, risk tolerance, and investment horizon. This comprehensive guide will help you understand the differences between positive and negative gearing and determine which strategy aligns best with your objectives.
Understanding Gearing
Gearing refers to borrowing money to invest in an asset, such as property. The terms positive gearing and negative gearing describe the relationship between the income generated by the investment and the costs associated with owning it.
- Positive Gearing: Occurs when the rental income from a property exceeds the costs of owning it, including mortgage interest, maintenance, and other expenses. This results in a net profit.
- Negative Gearing: Happens when the costs of owning a property outweigh the rental income it generates, resulting in a net loss. This loss can often be offset against other taxable income, reducing your overall tax liability.
Positive Gearing: Pros and Cons
Pros
- Immediate Income: Positive gearing provides a steady stream of surplus income from day one. This can be used to pay down the mortgage, save for another investment, or cover other expenses.
- Financial Stability: With positive gearing, you are less reliant on capital growth to make a profit. This can provide more financial stability, especially in uncertain markets.
- Easier to Build a Portfolio: The additional income from a positively geared property can improve your borrowing capacity, making it easier to secure loans for further investments.
Cons
- Higher Tax Liability: The surplus income generated by a positively geared property is taxable, which can increase your overall tax liability.
- Potential for Lower Capital Growth: Positively geared properties are often found in areas with lower capital growth potential. While they provide immediate income, they may not appreciate in value as quickly as properties in high-growth areas.
- Market Volatility: Positively geared properties can be more volatile in times of high-interest rates and slow rental price growth, making it more challenging to maintain a positive cash flow.
Negative Gearing: Pros and Cons
Pros
- Tax Benefits: One of the primary advantages of negative gearing is the ability to offset property losses against other income, such as your salary, thereby reducing your taxable income and overall tax liability.
- Potential for Capital Growth: Investors often use negative gearing to acquire properties in high-growth areas. While the property may operate at a loss in the short term, the expectation is that it will appreciate in value over time, leading to significant capital gains upon sale.
- Leverage: Negative gearing allows investors to leverage borrowed funds to control a more valuable asset, potentially leading to greater long-term returns.
Cons
- Cash Flow Challenges: Negative gearing requires you to cover the shortfall between rental income and expenses out of your own pocket, which can strain your cash flow.
- Risk of Interest Rate Increases: If interest rates rise, your mortgage costs will increase, potentially widening the gap between income and expenses and exacerbating cash flow issues.
- Dependence on Market Conditions: The success of a negatively geared strategy relies heavily on property market performance. If property values stagnate or decline, you may not realise the expected capital gains.
Case Studies
Positive Gearing Example
Chris’s Investment Journey
Chris, a hairdresser, saved a $170,000 deposit over the years and purchased an inner-city apartment for $425,000. He rents out the property for $2,000 per month, while his mortgage and other expenses total $1,000 per month. Chris enjoys a positive cash flow of $1,000 per month (or $12,000 per year). This surplus income allows him to pay down his mortgage faster and save for future investments.
Negative Gearing Example
Reveka’s Investment Strategy
Reveka, a builder, bought an apartment in a gentrifying suburb with a 15% deposit. Her annual rental income is $20,000, but her mortgage interest and other expenses total $29,000, resulting in a $9,000 loss. She offsets this loss against her taxable income, reducing her tax bill by $3,000. While Reveka incurs a net loss of $6,000 annually, she is banking on the property’s long-term capital growth to achieve her investment goals.
Choosing the Right Strategy
The choice between positive and negative gearing depends on several factors:
- Financial Goals: Consider whether you prioritise immediate income (positive gearing) or long-term capital growth and tax benefits (negative gearing).
- Risk Tolerance: Positive gearing offers more financial stability and less reliance on market conditions, while negative gearing involves higher risk but potentially greater long-term rewards.
- Cash Flow: Assess your ability to manage cash flow. Positive gearing provides surplus income, while negative gearing requires you to cover shortfalls until tax benefits are realised.
- Market Conditions: Research the growth prospects of the area where you plan to invest. High-growth areas can enhance the value of both positively and negatively geared properties.
Both positive and negative gearing have their advantages and disadvantages. The right strategy for you will depend on your financial goals, risk tolerance, and investment horizon. Positive gearing can provide immediate income and financial stability, while negative gearing offers tax benefits and potential for significant capital growth.
Before making any investment decisions, it’s crucial to consult with a financial advisor or tax professional to ensure your chosen strategy aligns with your overall financial plan. By understanding the differences between positive and negative gearing and carefully considering your individual circumstances, you can make informed decisions that help you achieve your investment goals.