What is negative gearing?
You won’t find the phrase ‘negative gearing’ in tax legislation.
It is a commonly used term used to describe a situation where expenses associated with an asset (including interest expenses) are greater than the income earned from the asset. Negative gearing can apply to any type of investment, not just housing.
Individuals who are negatively geared can deduct their loss against other income, such as salary and wages. This is consistent with the broader operation of Australia’s personal income tax system.
Australia’s tax system operates on the principle that people pay tax on their personal income, less any expenses (called deductions) in generating that income. This is similar to how business profits (that is, income less expenses) are taxed, ie tax is levied on the net profit of a business, not its gross revenue.
Deductions for costs incurred in producing income recognise that different people have different costs in producing income.
If negative gearing essentially means making a loss, why do it?
While making a loss on an investment property or shares might initially seem counterintuitive, some people are willing to do this in the expectation that the capital gain (sale price minus cost of asset) when they sell the asset will more than offset that loss.
Some people might also find themselves unexpectedly in a loss position, if they incur higher expenses or lower returns than anticipated.
Only 50 per cent of the increase in the value of the asset (when it is sold) is subject to income tax, providing it has been owned for more than 12 months.
There are also many non-tax factors that drive people to negatively gear property investment – for example, perceptions about the advantages of negative gearing and a bias towards investing in ‘bricks and mortar’, especially under certain market conditions; both of which might be fuelled by advice from property investment advisers and the media.
Why not link deductions with income from an asset?
Australia’s tax system allows for things like rental income to be added to an individuals’ taxable income in the same way as a small business can add net business income to income from other sources to determine taxable income.
This reduces the costs imposed on the economy from taxing business activities - without changing the incentives to invest.
Compared to a system that links income and deductions to their source, the Australian system reduces these potential distortions to the way people invest.
Who has negatively geared investments?
In 2012-13:
Over 1.9 million people earned rental income
Around 1.3 million of these reported a net rental loss
Nearly 70 per cent of people with negatively geared property had a taxable income of less than $80,000 per year
Assets like shares can also be negatively geared. In 2012-13, about 270,000 people deducted over $1.2 billion for expenses incurred in earning dividend income.
What is positive gearing?
Positive gearing is when the rental income exceeds expenses. In this situation, income greater than interest and other expenses is taxed at the individual’s marginal rates.
source: treasury.gov.au
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Borrowing money to invest
Borrowing money to invest where the return from the investment is less than the borrowing costs. For example, the rental income from your investment property is less than the interest payments on the loan used to purchase the property.
Borrowing to invest, also known as gearing or leverage, is a risky business. While you get bigger returns when markets go up, it leads to larger losses when markets fall. You still have to repay the investment loan and interest, even if your investment falls in value.
Borrowing to invest is a high-risk strategy for experienced investors. If you're not sure if it's right for you, speak to a financial adviser.
How borrowing to invest works
Borrowing to invest is a medium to long term strategy (at least five to ten years). It's typically done through margin loans for shares or investment property loans. The investment is usually the security for the loan.
Margin loans
A margin loan lets you borrow money to invest in shares, exchange-traded-funds (ETFs) and managed funds.
Margin lenders require you to keep the loan to value ratio (LVR) below an agreed level, usually 70%.
Loan to value ratio = value of your loan / value of your investments
The LVR goes up if your investments fall in value or if your loan gets bigger. If your LVR goes above the agreed level, you'll get a margin call. You'll generally have 24 hours to lower the LVR back to the agreed level.
To lower your LVR you can:
Deposit money to reduce your margin loan balance.
Add more shares or managed funds to increase your portfolio value.
Sell part of your portfolio and pay off part of your loan balance.
If you can't lower your LVR, your margin lender will sell some of your investments to lower your LVR.
Margin loans are a high risk investment. You can lose a lot more than you invest if things go sour. If you don't fully understand how margin loans work and the risks involved, don't take one out.
Investment property loans
Investment property loans can be used to invest in land, houses, apartments, or commercial property. You earn income through rent, but you have to pay interest and the costs to own the property. These can include council rates, insurance, and repairs.
Borrowing to invest is high risk
Borrowing to invest gives you access to more money to invest. This can help increase your returns or allow you to buy bigger investments, such as property. There may also be tax benefits if you're on a high marginal tax rate, such as tax deductions on interest payments.
Investment property loans continued…
But, the more you borrow the more you can lose. The major risks of borrowing to invest are:
Bigger losses — Borrowing to invest increases the amount you'll lose if your investments falls in value. You need to repay the loan and interest regardless of how your investment goes.
Capital risk — The value of your investment can go down. If you have to sell the investment quickly it may not cover the loan balance.
Investment income risk — The income from an investment may be lower than expected. For example, a renter may move out or a company may not pay a dividend. Make sure you can cover living costs and loan repayments if you don't get any investment income.
Interest rate risk — If you have a variable rate loan, the interest rate and interest payments can increase. If interest rates went up by 2% or 4%, could you still afford the repayments?
Borrowing to invest only makes sense if the return (after tax) is greater than all the costs of the investment and the loan. If not, you're taking on a lot of risk for a low or negative return.
Managing the risk of an investment loan
If you borrow to invest, follow our tips to get the right investment loan and protect yourself from large losses.
Shop around for the best investment loan
Don't just look into the loan your lender or trading platform offers. By shopping around, you could save a lot in interest and fees or find a loan with better features.
Don't get the maximum loan amount - Borrow less than the maximum amount the lender offers. The more you borrow, the bigger your interest repayments and potential losses.
Pay the interest - Making interest repayments will prevent your loan and interest payments getting bigger each month.
Have cash set aside - Have an emergency fund or cash you can quickly access. You don't want to have to sell your investments if you need cash quickly.
Diversify your investments -
Diversification will help to protect you if a single company or investment falls in value.
Gearing and tax
Borrowing to invest is also known as 'gearing'.
Before you borrow to invest, check if you will be positively or negatively geared, and how this will impact your cash flow and tax
Source: moneysmart.gov.au
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