Why Negative Gearing Should Be a Short-Term Investment Strategy

A little perspective from Tax Accountants who are also in the property game

As tax accountants, we frequently receive questions from our clients about the pros and cons of negative gearing in property investment. While negative gearing is a well-known strategy, many investors are unsure about its long-term sustainability and how it affects their financial situation, especially when it comes to taxes. We’ve put together this article to help understanding negative gearing a little deeper, how it impacts your tax position, and why transitioning to positive gearing or positive cash flow is usually recommended for building long-term wealth. We hope this will provide useful insights for our clients and others considering property investment strategies.

What Is Negative Gearing?

Negative gearing occurs when the costs of owning an investment property (such as interests, insurance, property maintenance, ongoing costs and management fees) exceed the rental income it generates. In other words, you are making a loss on the property. This loss can be used to offset your taxable income, which is why some investors opt for negative gearing as a tax strategy to lower their taxes. However, there are important financial considerations that can make it less beneficial than it first appears, especially over the long term.

The Appeal of Negative Gearing

In the short term, negative gearing can seem attractive due to these key benefits:

1. Immediate Tax Relief: The primary appeal is the ability to reduce your taxable income and lower your tax liability, especially if you are in the highest tax bracket.

2. Capital Growth Potential: Some investors choose negative gearing based on the expectation that property values will rise, and the eventual capital gains will outweigh the ongoing losses.

The Tax Implications of Negative Gearing

While negative gearing can provide short-term tax relief, it is essential to understand how it works within the context of your overall tax position.

1. Tax Refund Based on Your Tax Rate: When you use negative gearing, the losses from the property can be deducted from your taxable income. However, the tax refund you receive is limited to your personal tax rate. For example, if you're paying a 30% tax rate, you will only get back 30% of the property’s losses. Let’s say your investment property results in a loss of $10,000, you can reduce your taxable income by that $10,000. If you are in the 30% tax bracket, you will receive a tax refund of $3,000. The remaining $7,000 is still an out-of-pocket expense, which you must cover yourself.
   

2. Limited Tax Relief: It's important to understand that the tax refund is not a full reimbursement of the losses. You’re essentially only receiving a portion of your losses back in the form of a tax deduction. This means that the rest of the loss remains a financial burden on you. Over time, this can add up, particularly if you have multiple negatively geared properties or if your property isn't achieving significant capital gains.
   

3. Banking on Future Growth: Negative gearing is often seen as a strategy to reduce your tax bill in the short term, but the real benefit (such as capital gains) typically comes much later. Investors rely on the hope that property values will increase over time, compensating for the initial losses. However, if the market or the area where the property is located do not perform as well as expected, you may find yourself in a situation where the tax relief isn't enough to offset your ongoing out-of-pocket losses.

The Risks of Limited Borrowing Power for Future Investments

While negative gearing has its advantages in the short term, there is a significant future impact that investors should carefully consider.

1. Impact on Borrowing Power: Negative gearing can limit your ability to borrow for future investments. Lenders assess your borrowing capacity based on both income and expenses, including any losses from negatively geared properties.

2. Consideration of Losses: If you're consistently incurring losses on negatively geared properties, those losses will be factored into the lender’s assessment of your ability to service new loans.

3. Perception of Financial Stability: Ongoing losses, even if you have a steady income from other sources, could make you appear less financially stable to lenders. This can reduce your ability to access new loans.

4. Difficulty Expanding Your Portfolio: As a result, the financial strain of negative gearing may prevent you from meeting the requirements for additional loans, limiting your ability to expand your property portfolio.

Why Aim for Positive Gearing or Positive Cash Flow?

To build long-term wealth through properties, we would recommend investors to aim for overall positive gearing on their investment property portfolio, where the rental incomes from the properties exceed the costs of ownership. Positive cash flow properties may provide several advantages:

1. Steady Income Stream: Positive gearing means your property generates a positive income that can help cover living expenses or be reinvested into more properties. This regular cash flow can contribute to financial stability.

2. Reduced Financial Stress: With positive cash flow, you won’t have to pay out-of-pocket to cover property-related losses, reducing the financial strain. It makes your investment much more sustainable and less stressful, particularly in the long term.

3. Faster Equity Growth: Positive cash flow means your property is paying off its own mortgage, allowing you to build equity faster. This also frees up capital that you can use for further investments, enabling you to scale your portfolio more easily.

4. Positive Cash Flow Builds Flexibility for the Future: Positive cash flow today can offer you the flexibility to manage potential market fluctuations. While property markets can vary, the extra rental income can provide a buffer if the market experiences a dip in the future.

To Sum It Up

Negative gearing may offer short-term tax relief, but it’s important to understand that the benefits are limited. That said, negative gearing can be an acceptable strategy in certain circumstances—particularly when the property market is performing well and you’re focused on long-term capital growth. In these situations, the investor is willing to hold onto the property and accept short-term losses in exchange for future capital gains.

However, for long-term financial stability, transitioning to positive gearing or positive cash flow is still recommended.

Understanding the full tax implications of negative gearing, as well as how it fits into your broader investment strategy, is crucial for making informed decisions. While negative gearing can offer short-term tax benefits, its real value depends on long-term outcomes, which aren’t always guaranteed. Every investor’s situation is different, and having the right guidance can help bring clarity. If you ever want to explore your tax strategies or simply talk things through, we're always here for a conversation — no pressure.

Scroll on for General Advice Disclaimer.

General Advice Disclaimer

The information provided on this website is intended for general informational purposes only and should not be construed as professional advice. The advice and recommendations on this site are not intended to replace individual consultations with a qualified professional.

The application of tax, accounting, and business advice varies depending on personal circumstances, and the laws, rules, and regulations are subject to change. Therefore, readers should not rely solely on the content provided, and should always seek professional guidance tailored to their specific needs before making any decision.

W&G Taxation and Accounting accepts no responsibility for any loss or damage, including but not limited to indirect, incidental, consequential, or punitive damages, arising from actions taken or not taken based on the information provided on this website. We recommend that you consult with us directly for advice suited to your unique situation.