Whenever there is any kind of economic strife within the country, or when governments begin to discuss budgets, negative gearing becomes the whipping boy on which almost everything is blamed.  There’s a lot of emotion around the discussion about negative gearing, with the opponents claiming it is a rort for the wealthy, while the proponents claim that it continues to prop up many otherwise lacklustre property markets.

Before you begin to invest in property, or take part in any debate about negative gearing, you must first know what the term means.  Too many people lack real knowledge about this area, yet form an opinion about it anyway. To understand this, let’s start with the second part of the term – gearing. 

What is gearing?

Gearing is the term used to describe the process of increasing the size of your investment through borrowing.  Typically, when you gear an investment, you use that investment as security to access more funds, which in turn buy more of the assets.  When you gear an investment, the results can be that you either receive a negative outcome - negative gearing, or a positive outcome - positive gearing.  It is important to note that both outcomes are based on borrowing and both outcomes are based on the amount of tax that you pay as an individual, and so the amount of tax break you can receive.

What is negative gearing?

Many people believe that negative gearing is a strategy that explains how people on high incomes get back more of their tax.  But it is not a strategy at all – it is a tax outcome. In fact, the definition of negative gearing is:

‘Gearing your investment so that the cost to maintain it (loan repayments, yearly investment costs and expenses) outweigh the income produced by the investment, leading to a reduction in taxable income.’

In other words, negative gearing happens where the total yearly costs of any investment outweigh the total income, and you’re allowed to claim a loss against income earned elsewhere.  But, you can never get more than 45% of the loss back, and you’ll always have to pay the other 55% yourself.  The pay-off for meeting this commitment is considered to be the hope that the asset you purchased increases in value over time by more than the amount of money you lost as a result of holding it!

What’s positive gearing?

If negative gearing is an outcome whereby the costs exceed the expenses, then positive gearing is the opposite, and results where the income on an asset you invest in exceeds the expenses.  For property, this would occur if you purchased a property that had a high yield for your purchase price.  With interest rates low and remaining that way, reducing the yearly costs of holding an investment property, and rents coming under pressure in many areas and so increasing, more incidences of positive gearing are being seen and some people, who initially negatively geared, are seeing these properties now returning a positive income.  

What’s positive cash flow?

While both positive and negative gearing are fairly straight forward, and are the result of a simple equation of taking expenses away from income and assessing the result, the real confusion comes with the third tax outcome - positive cash flow.  This is a tax outcome that always happens when you positively gear – the fact that the income is higher than the expenses will always mean that you end up with money left over, even if some is lost in tax. However, even a negatively geared property can have a positive cash flow, if the on-paper deductions provide enough additional tax back to close up the gap.  

What are on-paper deductions?

On-paper deductions are those deductions an investor can claim where money hasn’t been actually paid out as an expense – but part of the asset has lost value.  They are the deductions that result from the perceived yearly loss in value of the building, and in some cases, the plant and equipment inside that building.  In a nutshell, for each one dollar of reducing value of the claimable part of the asset, you can receive as a refund your marginal rate of tax.  So, for example, if the building declined in value by $5,000 each year, you receive up to $2,250 in tax back, with nowhere to spend this money, as it is an on-paper, rather than an actual expense.  If that same property had good rents that were close to covering the expenses, then this additional sum of tax back could close that gap and result in a positive cash flow.  

And so, you can see that, even when you ‘negatively gear’ you may not end up with a negative cash flow, and it is very important to understand that negative gearing or positive gearing is actually not the most important factor for you as a property investor – it is the final result, or bottom line cash flow (after all your tax claims are made) that governs your ability to hold an investment over the long term, even when growth is low.