Gearing – Positive, Negative and Neutral
When you borrow money to make an investment it is called gearing and it is very often linked to discussions regarding investment properties. Depending on the income earned from an investment, there are three types of gearing: positive, neutral and negative.
Positively geared properties – this is where the rental return (the amount of rent you receive from your tenants) is higher than the costs of interest repayments and outgoings.
Negatively geared properties are when the rental return is less than the costs of your interest repayments and outgoings. In this situation the property investment is causing a loss.
Neutral gearing is where you earn the same amount from your investment as you pay in interest and other costs, such as rates, insurance and renovation work.
As per current Australian tax law, you may be able to claim the interest portion of your loan repayments and also some other costs as an expense, providing that the property is available to be rented.
One of the key advantages of negative gearing is that the loss associated with the property ownership may be offset against other income earned, such as salary, reducing your taxable income and therefore the amount of tax payable.
In some situations, the savings gained through tax deductions can exceed the losses realised from the property – with the overall result being that the cost of owning the property is being funded by your tenant in the form of rents paid, but also by the Australian Tax Office in the form of tax savings, and by your other surplus cash flow, such as your savings and other forms of income.
With positively geared properties, the surplus income generated can be put to other uses and other investments or just set aside to meet any future increases in costs or loan repayments.
It is a well-established practice for higher taxpayers to seek out a negatively geared investment property to maximise their tax returns and at the same time they also seek a hoped for increase in the long-term capital growth of the property.
Property investors closer to retirement or in a lower income bracket, may choose positively geared investments as they are keen to increase their income earning potential.
Gearing can help increase an investment’s return but also can magnify losses, and so requires careful consideration and the seeking of professional advice before making decisions.