Due to the endless increasing regulation in our industry, I need to start by telling you that I am not a Tax Advisor or an Accountant so the contents of this blog (and all my blogs) constitutes general advice only. I am only hoping to try and explain these concepts in a way that is easy to understand. If you need advice specific to your situation make sure you contact your Accountant or Tax Professional.
Living in Australia you will no doubt have heard the words ‘negative gearing’ over and over again but most people, even if they have adopted a negative gearing strategy still don’t actually know or understand how it works or why they are doing it. Negative gearing is one of the most popular investment strategies in the country. However, for the majority of people, especially if you aren’t in a property boom, it may not be the best one.
To explain the basics of negative gearing it is easiest if you think of the property as a business. It has income (rent) and expenses (mostly interest and other property holding costs such as management fees, rates etc) and if the expenses are more than the income the property will run at a loss. This loss is then deducted from your taxable income thus reducing the amount of tax you pay. Let’s say the property runs at a $10,000 loss, this means you have to contribute about $200 a week out of your pocket to keep the property. This doesn’t sound overly attractive unless the property increases in value more than the loss you are incurring which to be fair, over the last 15-20 years (other than a slight blip with the GFC) up until recently, generally property has done that.
Generally speaking, Australians hate paying tax and negative gearing reduces your taxable income which is how this strategy is spruiked by marketeers. If you have purchased in an area with little or no capital growth then you are literally paying $1 to save 30 cents (depending on your tax bracket).
The other issue with negative gearing is that because you are making a loss and having to contribute money to the property week on week you are reducing your borrowing capacity as you have less income than you had before you purchased the property. This will put the brakes on in terms of the growth of your property portfolio until such time as you earn more money or invest in positive cash flow/positively geared property.
Negative gearing generally only really benefits the mega rich but has been sold to the average Australian as a tax minimisation strategy. There is a time and a place for all investment strategies but the key is to make sure you understand what the strategy is, why it suits you and whether it suits the economic factors at the time.
Positive cash flow property or positive gearing is the opposite. The property runs at a profit and instead of you having to chip in money every week, the property puts money in your pocket every week thus increasing your income. Yes, increasing income means you will pay more tax but paying more tax means you are making more money so I’m down with that! There are still ways to reduce your tax bill with a positive cash flow property such as depreciation but that’s a conversation for your accountant. In an ideal world you would want a positive cash flow property AND to get some capital growth however it is less common to find positive cash flow properties in capital cities (where generally the highest capital growth is) unless you do things like add extra bedrooms or a granny flat.
One of the benefits of a positive cash flow property strategy is it is less likely to restrict the growth of your property portfolio as every property you purchase puts you in a better income position. You let them pay themselves off and at some point in the future you will own them all and earn a good income from them. I just wish I purchased mine 10 years ago instead of investing in negatively geared property, as I’d be closer to being able to retire. Hindsight is a wonderful thing!
The ASIC Money Smart website is a great resource and they have some case study scenarios which compare the 2 strategies. They also explain both strategies in detail (and probably better and with less bias than I have) so if I have confused you even more, head over to their website and have a read.
It isn’t too late to review your property and investment strategy. I got rid of my underperforming properties, changed strategies and am in a much better position in a short period of time. If you haven’t started investing yet and don’t have a huge amount of savings, there are opportunities everywhere at smaller purchase prices. Please don’t hesitate to reach out if you want to chat about your options.
“Real estate investing even on a very small scale, remains a tried and true means of building and individual’s cashflow and wealth” Robert Kiyosaki