The pros and cons of negative gearing: how does it affect investors?

Negative gearing was first introduced in Australia in 1985 as part of the federal government’s tax reform package. The government at the time hoped it would “reduce tax sheltering opportunities in the rental property area,” according to former prime minister Paul Keating.

In financial terms, gearing refers to borrowing money for investment purposes. It is either referred to as negative, positive, or neutral, depending on the cost of the investment compared to the income earned from said investment. For example, if an asset earns you more money than the cost of running or maintaining said asset, it is said to be a “positively” geared asset.

In Australia, when investors earn less income from their property (rent) compared to the expenses paid to run the investment (interest charges, insurance, council rates, maintenance and repairs), the net loss can be claimed against their total taxable income. This tax strategy is colloquially referred to as negative gearing.

Come tax time, investors can reduce their taxable income by this loss, ultimately lowering the amount of tax you must pay to the Australian Taxation Office (ATO).

Investment incentive

One of the primary advantages of negative gearing is that it encourages individuals to invest in the property market. The tax benefits can provide an attractive incentive for potential investors, especially those seeking long-term capital growth. This increased investment can lead to a more robust real estate market and greater housing supply, potentially contributing to economic growth and job creation in construction and related industries.

Portfolio diversification

For some investors, negative gearing can offer an opportunity to diversify their investment portfolio beyond traditional assets, such as stocks and bonds. Property investments can act as a hedge against market volatility, providing a tangible and potentially appreciating asset that can help balance overall risk in your investment portfolio.

Encouraging retirement planning

Negative gearing can play a role in retirement planning for some individuals. Property investment, particularly with negative gearing benefits, can be seen as a strategy to build wealth over the long term. Investors may view real estate as a way to secure a steady income stream during retirement, either through rental income or by selling the property at a higher value later on. 

This perceived financial security can provide peace of mind to investors, encouraging them to plan for their retirement and reduce reliance on government pension schemes in the future. However, it's important to note that this benefit may primarily apply to investors with substantial financial means who can weather short-term negative cash flows from their property investments.

Rental property availability

With more investors participating in the property market, there is a greater supply of rental properties available. This increased availability can potentially benefit renters, giving them more options and potentially moderating rental price increases.

Cash flow strain

Negative gearing can create significant cash flow strain on property investors, especially in the initial years of ownership. Since rental income may not cover all expenses, investors may have to subsidise the negative cash flow from their own pockets. 

This burden can be particularly challenging for those who have multiple negatively geared properties in their portfolio, tying up a significant portion of their income and limiting their ability to invest in other assets or opportunities.

Reliance on capital growth

Many investors who adopt negative gearing as a strategy rely heavily on the expectation of substantial capital growth to realise profits. They anticipate that the property's value will increase over time, offsetting the losses incurred through negative cash flow. However, this reliance on capital growth is not guaranteed, and market conditions, economic factors, and location-specific dynamics can all impact property values. 

In the event of stagnant or declining property prices, investors may find it difficult to recoup their losses through resale, potentially leading to long-term financial setbacks.

Interest rate risk

Property investors with negatively geared properties are exposed to interest rate fluctuations. If interest rates rise, mortgage repayments will likely increase, further widening the gap between rental income and expenses. In such scenarios, investors may face higher financial stress and reduced overall returns on their investment. 

While interest rate risks can be managed through fixed-rate loans or other strategies, it remains a factor that investors must carefully consider when adopting negative gearing as a strategy.

Housing affordability

One of the most significant drawbacks of negative gearing is its potential impact on housing affordability. The tax advantages of negative gearing can drive up demand for investment properties, leading to increased competition and higher property prices. As a result, first-time homebuyers and lower-income individuals may find it more challenging to enter the property market, exacerbating housing affordability issues.

Influencing investors

Negative gearing can distort the property market dynamics by skewing investor preferences towards existing properties instead of new construction. Since negative gearing relies on claiming tax deductions for expenses, investors may be more inclined to invest in older properties that typically require more maintenance and repair costs, instead of new properties that may have fewer expenses but offer better energy efficiency and modern amenities.

Property market volatility

During periods of economic downturn or rising interest rates, negatively geared properties can become a financial burden for investors. When rental income fails to cover expenses, investors may face financial stress or be forced to sell their properties, potentially contributing to market volatility.