opinion

Positive gearing, negative gearing... what does it all mean?

By Adrian Stagg
0

adrian tnLet's cut through the maze about Positive gearing vs Negative gearing & Positive Cash-Flow vs Negative Cash-Flow. Which is best and what do they mean?

Blogger: Adrian Stagg, Embark Intelligent Property Investment

Many people are confused by these terms, not fully understanding their meaning & importantly, the impact of & on their personal circumstances. So let’s try and cut through some of the bunkum surrounding these terms. Before one can answer “which is best?” a more thorough understanding of the meaning of the terms is necessary

Some of this might seem fairly obvious but please bear with me.  

Firstly. The following discussion relates only to investment property here in Australia. As investing in property is considered to be a taxable activity, any income earned or losses made in respect to that investment will impact ones overall personal income and therefore tax payable.

So putting income tax considerations into the mix, as one must, is really what causes the confusion.  What is a positively geared property for one person could be a negatively geared one for another. This is entirely due to their different income tax situations.

So it’s not the property that determines whether an investment is negative or positive, it’s the way that the holding entity (the owner) is structured, their resulting tax position & the choices they make. After all, most developed properties will have a positive cash flow before the cost of borrowing is taken into account.

Firstly, to break the terms down a little, the word ‘gearing’ refers to ‘borrowing money’ to help with a property’s purchase, whereas ‘cash flow’ refers to the ‘cash’ income that the property earns. It has nothing to do with tax credits, although tax credits, if available to you, when combined with other income that you have, may ultimately result in more ‘after tax’ cash in your pocket.

A property with positive cashflow means the rental income from that property will cover all of the outgoing cash costs (interest, council rates, body corporate, agent’s management fees and so on) associated with that property.

A property with negative cashflow means the rental income from that property does not cover all the outgoing cash costs associated with that particular property. That is, it makes a loss. It is this loss that reduces a person’s overall tax liability.

Adding the word ’gearing’ to these terms simply means that the property has been acquired using finance (borrowings) and that interest on that borrowing forms part of the outgoings.

Obviously then, the amount of that borrowing and the interest rate paid when combined with other cash outgoings, will determine if the property has a positive or a negative cash flow. The higher the borrowed amount the more likely it is to have a negative cash flow.
Right? Well, maybe but then maybe not.

Purists would argue, and reasonably so, that the total cost of the property needs to be considered in this equation, not just the amount & cost of the loan taken out, as there is an opportunity cost associated with the deposit. This is very real and especially felt where the deposit is borrowed but can also include lost interest (after tax) on savings that may have been used to pay that deposit.

Regardless, it now becomes apparent that a person’s individual circumstances as well as choices start to play a part in the outcome.

This is even more apparent when income tax considerations are considered in the equation.

Can a ‘negative geared’ property have a  positive cash flow?

The answer to this is ‘yes’ but only after income tax considerations have been taken into account. That is after you have taken tax credits gained from legitimate tax deductions into account.

These deductions can include that ‘negative cash flow’ as well as ‘non cash’ deductions such as depreciation which will vary from one property to the next. The actual amount of tax rebated (credited) to you by the tax department will vary from one tax payer to the next and will depend on your marginal tax rate. So, if the tax credits exceed the negative cash flow (pretty rare) then your negatively geared property will now have a positive cash flow, but only after tax.

Utilising the tax credits does not mean waiting until the end of the year to get your tax back. A ‘tax variation form’ allows you to get your tax back as you are paid (PAYG). You can get this form off the ATO website. Using this will reduce the tax deducted each pay period, resulting in more cash in your pay packet.

Caution needs to be exercised here as almost always when these types of investments are being sold, the promoter uses the top marginal rate (ie. the rate that applies to the highest income earners) in the calculations being used to promote the property. You should use the rate that will apply to yourself after taking into account your ‘existing’ deductions that could include all sorts of things such as motor vehicle expenses, tuition fees or other negatively geared property already held, as, even if you are on the top rate, your existing deductions may bring you below it.

If you are approaching retirement, not only is your marginal tax rate very likely to change at that point, affecting the amount of any cash rebate, but you may not have sufficient surplus cash earnings needed to support a negatively geared property.

So, why do people buy negatively geared property?

Make no mistake about it, leaving tax considerations aside for a moment, a negatively geared property is a loss making proposition.
So, why would people buy them?

The answer is simple. Firstly because they expect that, over time, the value of the property will increase at a high enough rate to cover the loss. This we call ‘capital gain’. Secondly, over time, they anticipate that the future rental income will increase sufficiently so that it covers the week to week losses that a negatively geared property incurs.

Looking at the first of these considerations. You can only realise that capital growth through either sale or re-financing the property. If you sell to realise the capital gain that immediately creates a taxable event, which is highly likely to mean that some of that gain is payable to the ATO. The amount payable will depend on the ownership structure & the taxpayer’s own circumstances, marginal tax rate etc. For most people 50% of the gain is added to their personal income.

If you re-finance the property to realise the gain that will come at a cost, viz: interest. The more you borrow the more interest you’re liable to pay. Hopefully rents will have increased sufficiently to cover the increased interest cost burden.

What about risk?

All investments come with an element of risk, not just property.

With property some of those risks you can insure against (at a cost) such as fire, flood, storm damage, loss of rent, etc.

There’s always a cost to lower risk. As is often said, “the lower the risk, the lower the return” which is usually true.

One of the risks with a negatively geared property, and it’s a big one, is that it’s value may not increase sufficiently to cover the loss.

Another is that interest rates may rise. Many people have been caught out by both these. Of course there’s also the issue of time taken to achieve capital gains, not to mention the uncertainty of achieving them. Many experienced commentators are predicting that in future, capital gains will take longer to achieve than has been our past experience.

So, what about Positive Gearing?

Many so called positive geared property offerings frequently, on full investigation, are not positive at all. Regardless, they are often located in far flung places that are heavily dependent on one (or maybe two) industries where the town’s fortunes fluctuate with the market price of the commodities of those industries, eg coal.

A small change in that commodity’s price making that industry unviable can quickly turn a boom town into a ghost town.
Property that is  truly positively geared, and I’m talking mainstream residential property (not retirement villages, student accommodation, motel units etc is extremely rare and not readily or easily available in areas that have potential for good long term capital growth.

Once again the risk is uncertain capital gain & possibly even income.

Which is better, Positive OR Negative?

In answering this question we will go into much more depth next month  and include some real examples to illustrate the points however, meanwhile, it’s important to note that there are choices and solutions available to property investors

So what’s the solution?

Well, the answer to that will vary depending on a person’s own personal circumstances. It’s also true that those circumstances may exclude them from some solutions that are available to others & therefore push them toward investments that may not really be in their best interests. So yes it’s true; some people have more choices than others, a fact of life that applies to things other than property.

There are solutions however outside the ‘traditional’ norm that show much better returns than the traditional norm.

Ask yourself

“What if you were able to build in those capital gains at the outset with good quality, well located residential property”?

That would be a solution to most investor’s desires and it is available to some (not all) investors. Our  Property Ladder Shortcut enables investors to eliminate the wait for capital gains and substantially reduce the time taken to build a portfolio that can be geared either positively or negatively to suit the investor’s own circumstances.


About Adrian Stagg
adrianAdrian Stagg is a director of Embark Intelligent Property Investment &  has been actively involved in the property industry since the 1970’s. His first foray at an unusually young age was as an investor.

Since then he has worn the hats of Real Estate Agent, Renovator, Builder, and Property Developer and of course, home owner. Through all these years, he has witnessed several cycles in property markets and now guides clients looking for ‘an edge’ in their journey through  property investment strategies and runs property investment seminars. Check out his blog where he shares his insights on smart property investment and how to get through the property maze.

promoted stories

Top Suburbs

Highest annual price growth - click a suburb below to view full profile data:
1.
FAIRLIGHT 46.02%
2.
CASUARINA 44.36%
3.
THE ENTRANCE NORTH 41.09%
4.
ULTIMO 40.67%
5.
LAVENDER BAY 40.2%