Negative gearing is a popular investment strategy, particularly in real estate, where the cost of owning an investment property exceeds the income it generates. The loss incurred can often be used to reduce taxable income, which is why many investors see it as a tax-effective strategy. Understanding how to calculate negative gearing is essential for assessing the real cost and benefit of an investment, and for making informed financial decisions. Whether you’re a new investor or looking to expand your property portfolio, grasping the numbers behind negative gearing will help you understand its true impact.
What Is Negative Gearing?
Negative gearing occurs when the expenses associated with an investment such as loan interest, maintenance, insurance, and other outgoings are higher than the income it generates. This situation results in a net loss. In many countries, this net loss can be claimed as a deduction against your other income, which reduces your taxable income and potentially your tax bill.
Negative gearing is common in property investment but also applies to other types of investments like shares, provided the investment is funded with borrowed money.
Basic Formula for Calculating Negative Gearing
To calculate whether your investment is negatively geared, you need to compare your total annual expenses to your total annual income from the investment. The basic formula is:
Negative Gearing = Rental Income (Loan Interest + Operating Costs)
If the result is a negative number, then your investment is negatively geared.
Key Components in the Calculation
- Rental Income: Total income received from tenants over the year.
- Loan Interest: The interest portion of your mortgage repayments (not the principal).
- Operating Costs: Includes property management fees, repairs, council rates, strata fees, insurance, and depreciation.
Step-by-Step Guide to Calculate Negative Gearing
Step 1: Determine Rental Income
Calculate the total rental income your property generates annually. For example, if your property rents for $500 per week:
$500 x 52 weeks = $26,000 per year
Step 2: Calculate Annual Loan Interest
Only the interest portion of your mortgage is deductible, not the principal. Suppose your loan balance is $400,000 with an interest rate of 5%, the interest would be:
$400,000 x 5% = $20,000 per year
Step 3: Add All Operating Costs
Summarize all ongoing costs associated with maintaining the property. Example annual expenses might include:
- Property management fees: $1,500
- Insurance: $1,200
- Repairs and maintenance: $800
- Council rates: $1,600
- Depreciation (on building and fixtures): $2,000
Total operating costs = $7,100
Step 4: Combine Loan Interest and Operating Costs
$20,000 (interest) + $7,100 (operating costs) = $27,100 total expenses
Step 5: Subtract Rental Income from Total Expenses
$26,000 (rental income) $27,100 (expenses) = -$1,100 (negative gearing)
This shows your property is negatively geared by $1,100 per year. You can usually claim this loss against your taxable income, depending on local tax laws.
Other Considerations in Negative Gearing Calculations
1. Depreciation and Tax Deductions
Depreciation is a non-cash expense that reduces your taxable income. You may be able to claim depreciation on the building itself and also on fittings and fixtures. It is often advisable to have a professional quantity surveyor prepare a depreciation schedule for accurate claims.
2. Vacancies and Rental Changes
Don’t forget to account for possible vacancies. If your property is not tenanted for a few weeks in a year, it reduces rental income and affects your gearing calculation. Also, fluctuations in rental markets can impact your expected cash flow over time.
3. Principal Repayment
Even though principal repayments aren’t included in your tax deduction, they do affect your cash outflow. While negative gearing focuses on the tax impact, make sure your cash flow can support the full mortgage repayment.
Tax Impact of Negative Gearing
One of the main benefits of negative gearing is the ability to reduce taxable income. Suppose your salary is $80,000 and your negatively geared investment creates a $5,000 loss, your taxable income may drop to $75,000, reducing your tax liability accordingly.
This benefit can be significant, especially for those in higher tax brackets. However, the real savings depend on your marginal tax rate and the amount of the net investment loss.
Positive vs. Negative Gearing
It’s important to compare negative gearing with positive gearing to understand the long-term financial implications:
- Positive Gearing: When rental income exceeds expenses, leading to a profit. This income is taxable.
- Negative Gearing: When expenses exceed income, leading to a loss. This loss can often be used to reduce other taxable income.
While positive gearing provides immediate income, negative gearing relies on potential capital gains over time to make the investment worthwhile.
Is Negative Gearing Always Beneficial?
Not necessarily. Negative gearing can be effective if the property appreciates significantly in value. However, you are still making a loss each year and relying on future capital gains to offset those losses. It’s important to analyze your financial position, tolerance for risk, and long-term investment goals.
Overcommitting to negatively geared properties without solid financial backing can lead to cash flow problems. It’s also wise to consider changes in tax policy, interest rates, and rental market trends.
Tips for Managing Negatively Geared Properties
- Maintain an emergency fund for unexpected costs
- Review your tax position yearly with a professional accountant
- Ensure proper property insurance is in place
- Reevaluate rent regularly to keep up with market rates
- Plan exit strategies if property value stagnates
Calculating negative gearing is a critical skill for any investor aiming to maximize tax efficiency and long-term capital growth. By clearly understanding how to assess your investment’s income, expenses, and tax implications, you can make informed choices about your financial future. Negative gearing isn’t a one-size-fits-all solution it requires strategic thinking, proper planning, and constant review. Done right, it can be a valuable tool in wealth-building; done wrong, it can lead to financial strain. Always consult with financial and tax advisors before making major investment decisions involving negative gearing.