Negative gearing vs. positive gearing

What is negative gearing and how it works?

When a property is negatively geared, it means the cost of owning it is more than the income it generates. Because this strategy returns a loss, it can seem risky – but there are other benefits that can add up in your favour overall. For example, you can deduct some of your costs from your taxable income and potentially benefit from capital appreciation.

Benefits of negative gearing

You may wonder, ‘Why is negative gearing good?’ While you’re making a loss, your property’s capital value may be growing. Negatively geared investors are banking on their overall loss being offset by their property’s potential capital appreciation. Keep in mind, though, there may be tax implications (like capital gains tax) that you’ll need to factor in if or when you sell. Also, saving tax shouldn’t be the only reason for choosing an investment strategy.  However, it’s definitely worth factoring in as you weigh up the options.

Disadvantages of negative gearing

You’ll need to have enough cash flow to cover your losses until tax time comes around each year. Running negatively geared investment properties can also make it harder to build your portfolio, since your extra cash will be tied up. If you’re more highly geared (more deeply in debt) you’ll be vulnerable to rate rises too. 

Costs of negative gearing

Before you negatively gear a property, make sure you can afford the ongoing out-of-pocket expenses. If rates go up, you can’t offset the added expense by simply increasing your rent – and you don’t want to be forced to sell your investment property before your capital grows.

An example of negative gearing

Reveka is a builder. She doesn’t own a business but works for someone else.

Over the years, she’s saved up enough money to buy a trendy apartment in a slowly gentrifying outer suburb as an investment. The existing tenants pay around $20,000 a year in rent.

Reveka started out with a 15 per cent deposit. This means she’s highly geared (in debt) and is facing a large annual interest bill of $25,000.

She also has around $4,000 in expenses – including rates, insurance, body corporate fees, repainting the front room and fixing the garage door.

Overall, that’s a loss of $9,000 a year, which affected her pre-investment purchase lifestyle. But this isn’t as bad as it seems.

Reveka could use this $9,000 loss to reduce her taxable income – and by extension – reduce her tax bill. However, the tax rebate on this loss would only get realised at the end of the financial year (unless she applies to have her PAYG withholding varied).

With her tax rate at 33 per cent, let’s assume that Reveka can offset the $9,000 against her taxable income. This brings her tax bill down by $3,000. Now her out-of-pocket costs are only $6,000.

Given her ultimate goal of long-term capital growth, Reveka's comfortable making a $6,000 loss each year.

This is an example of negative gearing. While it’s a more complicated investment strategy, it can be a long-term option worth considering.

What is positive gearing?

Also known as ‘positive cash flow’, positive gearing is the traditional way of making money from your investment properties.

Basically, you just add up all your expenses (things like interest, maintenance, rates and insurance), and if the rent you’re receiving for the property is more than you’re spending on it, you’re generating positive cash flow.

Benefits of positive gearing

Having a positive cash flow means you’re likely to be making a profit from day one. With a higher income, you can start putting money aside for another deposit – and continue to build your portfolio that way. Or you might use the extra cash to pay down the principal on your mortgage. Either way, you’ll be in a better financial position for the future.

Disadvantages of positive gearing

The main disadvantage of generating a positive cash flow is that because you're receiving extra income, you'll have to pay more tax.

How yield affects positive cash flow

You can determine your yield by taking your gross annual rent and dividing it by your investment property’s purchase price (it’s calculated as a percentage).

As a general rule, the higher your yield, the more likely you are to have a property that’s in the positive. But don’t leave it to chance – as an investor, it's crucial to crunch the numbers before buying.

An example of positive cash flow

Chris is a talented hairdresser. He started out as an apprentice and worked his way up. A couple of years ago, he went out on his own and started up 'The Do'— a thriving salon on a busy shopping strip.

Over the past decade, Chris has steadily saved a $170,000 deposit to buy an investment property. He looked for a long time, missed out at a couple of auctions, but then saw the perfect inner-city apartment.

He took the plunge and used his $170,000 as a (40 per cent) deposit towards the $425,000 cost.

He found tenants easily enough and now the property generates $2,000 in rent a month. The mortgage, plus other expenses, total $1,000 per month. For Chris, that’s $1,000 of positive income a month (or $12,000 per year).

To calculate the yield, let’s divide $12,000 by Chris's initial $170,000 investment. The result? A 7.05 per cent return.

This is a positive cash flow.

Speak to an expert

It’s always a good idea to run your plans by an accountant or financial adviser before settling on an investment strategy.