What is positive gearing?

Positive or negative gearing? The mechanics of property investment can be confusing. Understanding the different strategies may help you to make better decisions when it comes to acquiring a loan.

An investment is positively geared when the rental income exceeds all property expenses, and although it’s less common than negative gearing, it’s an approach you may wish to consider.

Positive gearing may occur if you surrender a sizable deposit, thus reducing the amount you need to borrow and the interest you’ll accrue. Buying in a market where rental demand is high and when interest rates are low may also induce positive gearing.

In real estate jargon, a positively geared investment is known as a ‘cash flow property’, while a negatively geared investment is commonly referred to as a ‘capital growth property’.

On the surface, these two investment scenarios may seem relatively straightforward but there are varying benefits, drawbacks and risks that you might be unaware of.

How does positive gearing work?

Let’s say you purchase an investment property for $500,000 in an area where rental demand is high and you’re able to lease the property for $500 per week.

Property expenses, including any loan repayments, total $430 per week. After rental returns the property is paying for itself and yielding $70 in additional income per week.

This is an example of a positively geared investment.

What are the advantages of positive gearing?

• Passive income - Your earnings are increased and you may be able to use this to pay down your home loan.
• Diminished risk - Given that the property is paying for itself, your investment risk may be reduced if you can avoid rental vacancy. If you were to lose your job, you could still cover all necessary costs. You may also be able to avoid the need to sell under pressure or amidst unfavourable market conditions.
• Lender appeal - A positively geared property may enhance your capacity to secure further loans.
• Balanced portfolio - You can use the extra income from your positively geared property to cover some or all of the difference on any negatively geared investments.

What are the disadvantages of positive gearing?

• Upfront costs - You’ll likely need a significantly higher deposit in order to reduce the amount you need to borrow so that you can positively gear your investment.
• Tax implications - Any gains you make after expenses and repayments is considered taxable income.
• Lagging growth - Cash flow properties tend to be located in regional areas and may be subject to slower capital growth, compared with properties in metropolitan precincts.
• Localised risk - The area you choose to invest in may be reliant upon a particular industry, such as mining. If the local mining operation were to shutter, rental demand could temper and your investment risk may increase.

What is negative gearing?

A negatively geared property is an investment that incurs a net rental loss - your rental income is lower than your combined home loan repayments and relevant property expenses.

The Australian Tax Office (ATO) states that you can claim a deduction for losses sustained against your rental and other income - such as salary, wages or business earnings. If your other income isn’t sufficient enough to absorb the loss, you may be able to carry this forward to the next financial year.

One of the driving influences that encourages negatively geared investments is the expectation that the capital gains - the sale price minus the cost of the asset - when the property is eventually sold will offset any losses sustained over the short term.

Additionally, only half of the increase in the value of the property when sold is subject to capital gains tax obligations, so long as you’ve owned the property for more than 12 months.

So, when should you positively gear your investment?

Of the 2.2 million Australians that owned at least one investment property in 2019-20, more than half (53.6%) possessed negatively geared investments, according to the ATO’s latest research and statistics.

Therefore, a little less than half (46.4%) of investment properties in Australia were positively geared in 2019-20. In comparison, around two fifths (41.4%) of properties were positively geared in 2018-19.

This means that the proportion of positively geared properties is on the rise, up 5% year-on-year.

However, this strategy may not suit everyone’s financial situation. It may be more difficult to find a positively geared property and the associated risks could be greater than anticipated.

You may consider contacting the Australian Taxation Office and/or a qualified tax accountant for more information on how positive gearing could affect your taxes. A qualified financial adviser or a mortgage broker could also provide more personal advice on how this approach could affect your investment mortgage.

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