A question we are often asked is 'what is the difference between positive and negative gearing?' The answer is quite simple, but delving into the strategies and results of negative and positive gearing requires extensive research.
Basically, an investment is deemed to be 'negatively geared' if the investment as a whole costs you money. In simple terms, it means that if you have borrowed money to purchase the investment, the expenses such as interest and depreciation cost you more than the income you derive from the investment. So why would you want a negatively geared investment? Well, those on high incomes can reduce their tax liability including the income and expenses in their taxable income. For example, if you receive $8,000 in rent but have to pay out $14,000 in interest and other expenses, then your taxable income is reduced by $6,000. Those on the highest tax bracket (48.5%) would effectively net around $3,000 in tax benefits.
When analysing this type of negatively geared investment, it is important to look at the type of deductions, and whether or not they come straight out of your pocket. For example, interest is deemed to be a 'cash' expense, as this money must be paid to the bank. Depreciation however, is considered a non-cash deduction as you do not have to pay from your pocket. It is more a 'cost of ownership' expense that the tax office allows for. It is important to be aware of the level of expenses you are required to pay on a weekly or monthly basis, to ensure that you can afford the repayments.
If you have a negatively geared property and you expect to receive the benefits by offsetting your tax liability, then it may pay to put in place a 221D taxation variation. This is a piece of ATO legislation that allows an individual to reduce the amount of tax he or she pays through PAYE (pay as you earn) tax, knowing that their tax liability will be lessened by the deductions. This is quite a complex document that should be filled out, checked and lodged by a qualified accountant.
Another reason to negatively gear is for capital growth. An investment may cost you money to own on a weekly or monthly basis, but it means that you reap the benefits of capital growth on your investment. The average across Australia for the past ten years has been around 5% p.a., so on a $200,000 investment you can expect to get around $10,000 per year. This is of course subject to the location and quality of your investment, and the fact that the property market seems to fluctuate between high growth and nil growth over a cycle of around 6 years.
Positive gearing, on the other hand occurs when you have an investment that earns more money than the costs required to own and maintain the investment. This 'positive' aspect can be derived from either higher returns or lower deductions. The down side of a positively geared investment is that it will increase your tax liability, and if you are at the maximum marginal rate this equates to roughly half of your additional income. This scenario often occurs when the investment is purchased from existing funds, and the interest component is taken out. In this case, we recommend that the funds be used in capital-guaranteed bonds or some sort of managed share investment.
An example can be found with many so-called 'mum and dad' investors who have purchased Telstra shares. If these shares were purchased with money that had been saved up, then it may be better to sell the shares, put the money back into your home loan, and borrow the money against your home to repurchase the shares. This means that the interest payable for the shares becomes tax-deductable (as it was used for investment purposes), and the non-deductable portion of your home loan is lowered.
There are many implications of positive and negative gearing that must be addressed before any commitment to an investment is made.