What is negative gearing?

The rise in property prices have generally grown faster than the rental incomes in the last few years. With the rise of property prices, rental yields have fallen along the way. In fact, some investors who have bought properties recently find their properties are negatively geared.

Here’s how it works

Negative gearing happens when your rental income does not cover your expenses (interest repayments, rates, insurance, etc). This means you have to use other sources of income (wages, salary, incomes from other rental properties) to pay for the shortfall.

Negative gearing is usually more common in a boom part of the property cycle. When property prices are decreasing, banks usually are less willing to lend to finance negatively geared real estate investments. Also, Investors using a negative gearing strategy often choose interest-only loans, because they increase the tax-deductible expenses on your investment property (as you’re not repaying any principal). Banks are less comfortable with interest only loans in a recession, so that is also another reason why negative gearing is a less common strategy during a downturn in the property cycle.

Why would a property investor use negative gearing strategy? Property investors who use the negative gearing strategy do so for one or a combination of the following reasons:

  1. They expect the property prices to continue increasing (return from capital gains).
  2. They expect at some time in the future, the rents will increase (return from increase in yields).
  3. Effectively, the investor is making a net loss. In that case (depending on how the property transaction was structured), the investor can offset the loss against their personal income to reduce the amount of income tax. This tax advantage is often cited as the benefits of being negatively geared.

New investors who employ a negative gearing strategy often find themselves in an asset rich, cash poor situation.

They see their property prices rising, but have to manage their cash flow tightly to ensure they can pay the expenses (interest, insurance, body corporate levy, and other outgoings). Negative gearing can be risky if you are using your salary or wages to subsidise the property’s expense. If your income situation were to change (eg if you were to lose your job), then you may not have enough income to cover the costs of the investment and you are more likely to need to sell under pressure and potentially unfavourable conditions.

For that reason, is advisable to look for positive cash flow property investments and use negative gearing with extreme caution. At least when the property is positively geared, the rental income covers the expenses. This puts less pressure on the property investor on having to come up with extra funds to subsidise the property’s expenses.

In any event whether or not you choose to use a negative gearing strategy, you should always get professional advice before deciding to follow that strategy.

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