Negative gearing

what is negative gearing?

The days of saving to pay for something is well over, almost everything we buy nowadays is on credit, whether it’s your weekly shopping, the very large LCD TV, or an investment asset such as a property.

We borrow to pay for what we want to buy and pay it back later plus interest. So what does that have anything to do with negative gearing? Well negative gearing is a tax effective investment strategy of using credit (loans) to purchase an investment asset. The idea is that the income you’re receiving from that asset (e.g. rental from a property or dividend from shares) is less than the costs (interest and all other eligible expenses) you incurred to hold that asset for the tax year, in another word, you’re making a loss on the investment. The loss is then tax deductible, thus reducing your income tax for that year.

Why would you want to do that? Remember a loss is a loss, assuming that your average tax rate is 30, you can only get back 30 of the loss, you still lose 70 of the loss, a common mistake most people make is believing that you’ll get the full loss back, you wish! Obviously, the higher your tax rate the more you can claim back and therefore the more this strategy benefits you.

Negative gearing is not about making tax losses, far too many people think of negative gearing as a tax strategy rather than a tax effective investment strategy. Your decision to invest should be based on the potential of the investment making you richer or increasing your wealth in the long term, and giving the tax man less is an added benefit! Not the other way around, you should not enter into a loss making investment purely to reduce your taxes, you may be risking a lot more to save a few dollars in tax.

The only reason why you should negative gear is capital growth! You’re willing to accept the losses now hoping that the asset you bought will grow in value far greater than the losses you incurred. Furthermore, base on current tax laws, if you hold an investment asset for 12 months or more, you only have to pay capital gain tax on 50% of the gain! The other 50% is in your pocket tax free! Thus this strategy is very effective but only if you bought the right asset.

A word of caution.

As you can see, negative gearing is all about betting that the asset you bought is going to go up in value and improving your overall wealth in the long run. This strategy was very popular during the bull market of yesteryears when both the properties and shares market were going up and up. You can just borrow and buy almost anything and chances are you will make a profit. However, in this current market where the share market is in turmoil and the property market not doing that much better, you got to be very careful when deciding on which asset to negative gear on, the biggest investment mistake is paying too much for an asset therefore leaving no room for future capital growth.

See your accountant for specific advice surrounding negative gearing especially when investing in shares, managed funds or structured investment products. In the last federal budget, there were a few crucial changes that will limit the amount of interest you can claim on these investments, more reasons to ask for expert advice.

In summary, negative gearing is a wealth creation strategy taking advantage of favorable tax laws to maximise return. Negative gearing is not a tax reduction strategy, selecting the wrong asset to invest in will maximise your losses under a negative gearing strategy.