If you are into property investing, knowing your tax commitments is essential, as according to the Australian Taxation Office (ATO), rental income is taxable. But did you know that you can lower your taxable income depending on how your rental property is structured?
One of the first decisions you should be making when investing in a property is whether you’re going to positive or negative gear. You may have come across the term ‘gearing’, in property investments or in real estate, but you may not be sure what it means.
What is Gearing?
When it comes to investing, the term ‘gearing’ simply refers to borrowing to buy an asset. Basically, it is a way to describe borrowing to invest. When you buy property by taking out a loan, your investment is said to be geared.
Positive and Negative Gearing: Explained
Negative and positive gearing are two strategies that property investors sometimes use, depending on the situation and their long-term financial goals.
The main difference between them is with the income generated. Positive Gearing is when the income the investment generates is more than overall costs, that includes any home loan repayments and property expenses. This means it is generating a positive cash flow. This means profit. The downside to this strategy? Since you have a bigger income, your taxable income rises. So does the tax you pay.
Negative Gearing is the complete opposite. In it, the ongoing costs and loan repayments for the property are more than the income it generates. This means that the property is producing a loss each year right? Yes. However, investors claim this net loss against their total taxable income at tax time. This means they pay less taxes.
How do you know which one would work best for you?
Positive Gearing: Pros and Cons
- Cold hard cash- You have more money in your pocket which you can save for a deposit to invest in more properties or to pay off your investment loan.
- Higher income increases your borrowing power.
- People new to investing or those about to retire may not want to be burdened by too much debt so a positive cash flow tends to make more sense.
- Great equaliser- having positively-geared properties can help cover any losses incurred if you have negatively-geared properties.
- You’ll get taxed- ATO will take higher tax as your taxable income increases.
- Slow capital growth- Most positively-geared investment properties are located in rural or regional towns, and growth rates tend to be slower compared to metro/city areas.
- Incomes are low in a high-property growth environment. This can have a negative effect on your positive cash flow strategy.
- Fluctuating growth- You rely on good economic factors like low-interest rates and low vacancy rates, which could go bust one day due to any reason.
- Unexpected costs: Maintenance and repair costs could throw out your cash flow.
Negative Gearing: Pros and Cons
- Claim losses on tax- Any net losses on your investment property will reduce your taxable income, thus reducing the tax you pay.
- High capital growth- Having investment property in a location with strong fundamentals, selling it at the end of a property cycle (7-10 years) and you gain far more than any losses you’ve been hit with.
- Tighter cash flow: Owning a negatively-geared investment property tends to have more success if you’re in a stable occupation and have a regular income, so you can cover drawbacks or property costs. If the situation changes, you’re not in a position to increase rent so it can really squeeze your cash flow. At worst, you will be forced to sell the property.
- Tighter cash flow affects borrowing power: You cannot easily get approved for a loan with less income in your pocket.
Depending on your situation, both positive and negative gearing are strategies that could work for you.
Generally, a sustainable portfolio is all about balance. You could balance your negatively-geared investment property with your positively-geared one to offset the losses, and eventually, you’ll find your sweet spot between positive and negative gearing.
Overall, it is important to consult with experts and with people who have gone down the same path before.