Negative Gearing vs. Positive Gearing: Which Strategy is Right for You?
Investing in property is a popular wealth-building strategy in Australia. One of the key decisions property investors face is whether to pursue a negative gearing or positive gearing strategy. Both approaches have their own 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 negative and positive gearing and provide insights into which strategy might be best for you.
Understanding Gearing
Gearing refers to borrowing money to invest in an asset, such as property. The terms negative gearing and positive gearing describe the relationship between the income generated by the investment and the costs associated with owning it.
- Negative Gearing: Occurs when the costs of owning a property (including mortgage interest, maintenance, and other expenses) exceed the rental income it generates. This results in a net loss, which can be offset against other taxable income, reducing your overall tax liability.
- Positive Gearing: Happens when the rental income from a property exceeds the costs of owning it, resulting in a net profit. This surplus income can be used to pay down the mortgage or invest in other assets.
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.
Positive Gearing: Pros and Cons
Pros
- Positive Cash Flow: The primary benefit of positive gearing is the immediate positive cash flow. The rental income exceeds the expenses, providing you with surplus income that can be used to pay down debt or reinvest.
- Reduced Financial Risk: Positive gearing reduces your financial risk as you are not reliant on capital growth to cover losses. This makes it a more conservative investment strategy.
- Increased Borrowing Power: 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: Positive gearing increases your taxable income, which means you will pay more tax on the rental income generated by the property.
- Potential for Slower Capital Growth: Positively geared properties are often found in areas with slower capital growth. While they provide immediate income, they may not appreciate in value as quickly as properties in high-growth areas.
- Dependence on Rental Market: Positive gearing relies on the stability of the rental market. If rental prices drop, the property may no longer generate a surplus income, affecting your cash flow.
Case Studies
Negative Gearing Example
Consider Sarah, who purchases an investment property for $600,000 with a loan of $500,000. Her annual interest payments and other expenses total $33,000, while the rental income is $26,000, resulting in a net loss of $7,000. Sarah can offset this loss against her salary, reducing her taxable income and overall tax liability. She hopes the property’s value will appreciate over time, leading to significant capital gains.
Positive Gearing Example
Chris buys an investment property for $425,000 with a $170,000 deposit. The property generates $2,000 in rent per month, while the mortgage and other expenses total $1,000 per month. Chris has a positive cash flow of $1,000 per month, or $12,000 per year. This surplus income can be used to pay down the mortgage or reinvest in other properties.
Choosing the Right Strategy
The choice between negative and positive gearing depends on your individual financial situation, investment goals, and risk tolerance.
- Financial Situation: Consider your current cash flow and ability to cover potential shortfalls. Negative gearing requires a higher income to cover losses, while positive gearing provides immediate income.
- Investment Goals: If your goal is long-term capital growth, negative gearing may be more suitable. If you prefer immediate income and reduced financial risk, positive gearing might be the better option.
- Risk Tolerance: Negative gearing involves higher risk due to reliance on capital growth and potential cash flow challenges. Positive gearing is more conservative and less risky but may offer slower capital growth.
Both negative and positive gearing have their advantages and disadvantages. The right strategy for you will depend on your financial goals, risk tolerance, and investment horizon. Negative gearing can offer significant tax benefits and potential for capital growth, but it requires careful cash flow management and a long-term investment perspective. Positive gearing provides immediate income and reduced financial risk but may result in higher tax liability and slower 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 negative and positive gearing and carefully considering your individual circumstances, you can make informed decisions that help you achieve your investment goals.