Negative Gearing

Definition

Negative gearing is a financial strategy where an investor borrows money to invest in an asset, typically property, and the income generated by the asset (such as rent) is less than the expenses associated with owning and managing the asset, including interest payments on the loan. Essentially, the investment operates at a loss. The advantage of this strategy is that the loss can often be offset against other income, reducing the investor’s taxable income.

Phonetic

The phonetic pronunciation of “Negative Gearing” is “neh-guh-tiv geer-ing”.

Key Takeaways

1. Rental Losses: Negative gearing is a financial strategy commonly used in real estate, where an investor borrows money to invest and the rental income earned from the investment property is less than the interest on the loan, resulting in a profit loss.
2. Tax Benefits: The key advantage of negative gearing is that it can provide substantial tax benefits. The investor can offset the loss made on the property against their personal income, which reduces their overall taxable income.
3. Risk Considerations: It’s important to remember that negative gearing should be approached with caution. Although it can provide a good return in the form of tax benefits, it often relies on property value growth to offset the initial losses, which is not always guaranteed.

Importance

Negative Gearing is a crucial concept in business and finance as it refers to the scenario where the cost of owning a rental property, including interest on the loan taken for it and other associated costs, surpasses the income it generates. It is often considered a favorable tax arrangement as the shortfall can be used to reduce the tax payable on the investor’s other income, leading to significant tax benefits. Additionally, the strategy banks on capital growth where the property increases in value over time, thus making any losses a potentially worthwhile investment, even though it’s a riskier one. Awareness of negative gearing can help investors plan their investments strategically, considering both the tax implications and potential for long-term profit.

Explanation

Negative gearing is a financial strategy commonly utilized in real estate where an investor borrows money to invest in a property and the rental income generated from this property is less than the interest on the loan and other expenses. The main purpose of negative gearing is to leverage potential tax benefits that come with this kind of investment strategy. The investor is essentially betting on the fact that the potential long-term capital gains from the investment property will outweigh the short-term losses they incur from loan expenses exceeding rental revenue. Negative gearing is used to lower an investor’s taxable income, as the losses they incur can be offset against other income.

This can result in a lower overall tax bill for the investor. In the context of real estate, investors anticipate that over time, the property will increase in value and they will be able to sell it at a profit. Therefore, the potential positives of negative gearing are that it can provide significant tax benefits along with profitable property value appreciation. However, it carries risks, including uncertain property markets and potential difficulty covering loan repayments if renters aren’t found quickly.

Examples

Negative gearing is a financial strategy that is often employed in real estate investments but can also involve shares or other investments. It involves borrowing money to invest, and the income generated from the investment (like rent from a property) is less than the expenses (like interest on the loan, maintenance costs), causing a loss. This loss can usually be offset against other income which can reduce the investor’s taxable income and overall tax payable. Here are three real world examples:

1. Real Estate Investment: John buys an investment property for $500,000, paying interest of $30,000 per year on his loan. His rental income from the property amounts to $20,000 per year and he also has $5,000 in additional expenses like rates and maintenance, totalling $25,000. In this situation, John is making a loss of $5,000 annually on his investment, hence, it’s negatively geared.

2. Stock Market Investment: Sarah borrows money to buy shares in a company. The interest she owes on the loan is greater than the dividends she receives from the shares, causing her to make a loss on this investment. This is another example of negative gearing.

3. Business Venture: Anthony invests in a startup company by taking out a loan. The company is in its early stages and while it shows great potential, it has not yet started making substantial profits. The interest Anthony pays on his loan exceeds the income he receives from the business, thus he is negatively geared.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Investment Property: A type of real estate property that is purchased with the intention of earning back investment returns through rental income, the future resale of the property or both.
• Rental Income: The income received by an individual from the renting of a property that the individual owns.
• Interest Deduction: The expense that a taxpayer is allowed to deduct from gross income in order to reduce the taxable income.
• Capital Gains: The rise in value of a capital asset (like investment or real estate) that gives it a higher worth than the purchase price. Capital gain is not realized until the asset is sold.
• Tax Liability: The total amount of tax owed by an individual, a company or other legal entities to the tax authorities.

Sources for More Information

• Investopedia
• Corporate Finance Institute
• WallStreetMojo
• Wikipedia