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Negative gearing is a popular technique with Australian property investors because of its tax advantages, but it is not without risk.
There’s no doubt negative gearing has been one of property’s biggest buzz words in recent years. And there’s good reason why: with the right approach it can provide great tax advantages and cash flow benefits favoured by many landlords.
So what exactly is negative gearing and how does it work? Gearing essentially refers to the act of borrowing to invest. A property becomes negatively geared when the costs of owning it exceed the income it produces – i.e. you are making a loss.
Why would you choose this approach? For investors there is one key reason – to maximise the return on their initial investment, or in other words, minimise the amount of money that they put down on the property from their own pocket.
For a simplified example, an investor buys a $500,000 property, puts down $100,000 (or 20 per cent of the value) of their own money, and takes out a $400,000 interest only loan.
Over a 12 year period let’s say the property doubles in value, so it is now worth $1 million. When the investor sells the property, and repays their $400,000 interest only loan, they will recoup a gross figure of around $600,000.
That represents a gross return of $500,000 on their initial $100,000 investment. But remember that out of this figure there will be selling costs, any rental shortfall over the period and of course capital gains tax.
Nonetheless this opportunity to significantly magnify a small investment by gearing (or borrowing) remains popular as an investment strategy.
There are also associated tax benefits for negatively geared properties as there may be an opportunity for the landlord to offset any loss against their taxable income.
Take care however: negative gearing is a game that requires caution.
Be very wary of developers’ promises about the potential for future returns on an investment, and do as much research as possible to ensure you are making a sound investment.
It is also essential that you seek professional advice on the tax issues associated with negative gearing and never borrow beyond your means. If you have some concerns, or would like some more information, please feel free to get in touch.
Negative gearing occurs when the rental income of a property is not enough to cover the total costs of managing the rental and re-paying the interest portion of the loan.