Simply, negative gearing is a government protection for those renting properties. It is a financial tool for investors to act as a support for buying and renting properties.
It is in place to also regulate and encourage the rental market. With property prices booming and affordability declining, renting is becoming increasingly popular. Negative gearing is meant to protect that market and stop or slow exaggerated pricing.
An important point to clarify: we actually use ‘negative gearing’ in two ways. In a strict sense it just means that a property with higher interest repayments than rental costs is ‘negatively geared’. But more colloquially it is now used to reflect the government incentive for these particular properties.
HOW DOES NEGATIVE GEARING WORK?
Negative gearing works through a tax exemption. Simply, as an investor, if you take on a loan to purchase property, you would expect the rental returns to make you profit. That is the idea behind rental investment properties.
Hence, if the rental repayments do not cover your interest repayments then you are losing money on that property. This is because the loan will be increasing (with the addition of interest) without you paying it off.
Negative gearing allows for those investors to claim the difference on their tax recall in July.
To give an example, if an investor took out a $500 000 loan on a $600 000 property at a 5% interest rate, they would owe $525 000 at the end of the first year. I have simplified this: in real life interest compounds and would, therefore, be higher.
If the investor was renting the property at $400/week. They would earn $20 800 at the end of the year. If they paid this into the loan, their overall loan at the end of the year would be $504 200. This amount is higher than their initial amount before interest. Hence, they are accepted as negatively geared and would be able to claim $4 200 in tax back at the end of the fiscal year.
This is an over-simplified version as compounding interest and much shorter time frames affect how this is calculated.
Property tax exemptions can be very handy, find out more about tax exemptions for home buyers here.
HOW DO WE USE NEGATIVE GEARING?
This is where negative gearing comes to a crux. Negative gearing is built for investors. An investor is anyone who purchases a property for profit rather than function.
Negative gearing works as a tax recall when you fill out your tax return at the end of the financial year. If you have a documented rental property which is negatively geared you can claim the difference back.
Now, it may seem as though negative gearing is causing net neutrality. By this I mean, you neither make money, nor lose money.
For the majority of cases this is not true, you actually will make a profit. It is known as ‘unrealised’ profit. This happens as the value of homes naturally increases.
If we go back to the previous example. Imagine the value of the property had also grown to $610 000 in that year. Hence, you would have made a profit of $10 000, it would just be unrealised. Unrealised means it is tied up in an asset, it is not accessible or liquid funds.
We label it unrealised because until you actually sell the property, the value could drop and therefore you would lose that profit. Hence, realised profit is secured profit.
Hopefully this helps you better grasp negative gearing and how it can work for you. What is negative gearing is such a common question these days, take the simple version and run with it.