Negative gearing refers to the holing of an asset for a loss with the intention of making gains in the future. In Australia, negative gearing most commonly applies to real estate held by investors whereby the expenses to hold the asset exceeds the rental income derived from it. Most often the largest component of expenses relating to real estate are concerned with interest repayments on the loan taken out to finance the property.
Under the Australian tax system, the loss component of negatively geared rental properties can be used to offset income obtained from ordinary employment and other sources. This effectively discounts the inherent interest rate on the investment by the taxpayer’s marginal rate of tax. For someone earning more than $180,000 p.a. negative gearing could mean that the effective interest rate they pay on their rental property is discounted by 46.5%, which will significantly affect whether or not the investment is a sound one.
Despite the seemingly attractive tax benefits of negative gearing, there are a lot of misconceptions about the real benefit obtained. For instance, a negatively geared asset will require an injection of funds from the asset holder in order to keep the asset viable and pay the loan off. Most of the servicing costs of the negatively geared asset will come from an injection of funds from the asset holder rather than the tax savings. Many people wrongly assume that a positively geared asset is a bad thing, but such an assumption is fundamentally flawed. The goal of any leveraged investor is to hold an asset that pays itself off rather than an asset that requires constant support from the asset holder.
In most investment property scenarios, an investor will utilise the tax benefits of negative gearing to help pay down the principal on the loan which will in turn reduce the interest payments. Over time, as the principal is reduced, the rental payments received by the tenants of the rental property should cover the coats of the loan as well as the associated costs of holding a rental property. Once the rental property becomes positively geared, then the taxpayer will actually make a tax profit and will have to pay tax on the positive income amount at whatever their marginal rate of tax is. Whilst a positively geared asset will result in more tax been paid, the taxpayer will actually have more after tax income than they did when they were negative gearing.