What You Need to Know About Negative Gearing

Taking a loss can sometimes be a very good thing in the world of property investment. Even though it seems to defy logic, many Australians are making money from losses on investment properties by employing a strategy called negative gearing.

What Is Negative Gearing?

With negative gearing, a person uses a loan to buy a rental property. What’s different with this type of investment is that the interest payments on the loan may exceed the rent received. The buyer is effectively losing money on the rent, but he or she expects to make a lot of money down the line.

The money comes from rapidly rising property values. The buyer either expects to sell the property for a much higher price in the near future, or be in a position to refinance the loan at much better terms.

The popularity of negative gearing is being driven by Australia’s red hot real estate market. People are betting that property prices will keep going up, so they will be able to quickly sell the property and make a profit.

Negative Gearing and Taxes

Taxes are one of the main reasons why negative gearing has become so popular in recent years.

The Australian Tax Office (ATO) allows a person to deduct borrowing expenses when purchasing properties. This means somebody can deduct any losses he or she incurs from negative gearing from his or her income tax. This can help a person with a large income tax bill, such as a professional with a large salary or a business owner, reduce tax payments.

There are some ongoing expenses of building ownership such as maintenance fees that can be claimed as deductions. The cost of repairs, remodelling and large capital expenses such as plumbing and new appliances can also be claimed.

But there are many property-related expenses you cannot deduct from your taxes. These include expenses incurred by tenants and the actual cost of buying the property. Although you can use these to reduce capital gains tax if you sell the property, which favours negative gear investors.

If you want to engage in negative gearing you should talk to a tax professional before they start. Taxes can be tricky, and the last thing you want is to get into trouble with the ATO.

What Do the Experts Say?

Financial experts recommend that only high-income individuals with a good knowledge of real estate should engage in negative gearing. Knowledge of the real estate market is critical, because the properties have to be chosen very carefully.

There is a lot of risk to negative gearing because the person who employs the strategy is betting that property prices will keep going up. If they do not, he or she can get into deep trouble, and fast.

This occurred in America where the practice is known as “flipping.” During the U.S. real estate bubble of 2004-2007, many Americans used negative gearing to buy properties they intended to sell fast or “flip.”

When the market crashed, they ended up “underwater” – the amount the homes were mortgaged for exceeded the amount the property could be sold for. Many of the homes ended up in foreclosure and some of them are still sitting empty nearly 10 years later.

How Does it Affect People Buying and Selling Homes

Negative gearing affects home buyers by driving up the price of real estate. This is indeed an opportunity for property investors to make a profit, but it can force also home buyers to take out much higher mortgages than they normally would.

In the worst case scenario, it can lead to a “real estate bubble” in which prices surge sky high and suddenly collapse. Potential home buyers should be aware of negative gearing and stay out of the market if they see a lot of it occurring. That way they will not be stuck with a mortgage with that exceeds the value of their home.

Who Should Engage in Negative Gearing

Only persons who can afford to take the losses should engage in negative gearing. A person with a lot of extra cash, or a very good salary, can afford to speculate with property values. Somebody who is living pay check to pay check, or living on a smaller fixed income, should avoid it.

Generally, if you cannot afford to lose money, you should not engage in negative gearing.

Key Takeaways

People who want to experiment with negative gearing should very carefully study the practice, and the real estate market, before they start. If someone has any doubts that prices will increase, they should not buy.

It is possible to make money through negative gearing, but only those people with money to lose, a high tolerance for risk and confidence in their abilities should pursue negative gearing as an investment strategy.