Negative gearing - definition & overview

Negative gearing is a financial strategy commonly employed in the world of small businesses and property investment. It is a concept that can be complex to understand, but once grasped, it can be a powerful tool in the arsenal of any small business owner. In essence, negative gearing involves making an investment that is expected to produce a taxable income which is less than the expenses associated with that investment.

It's a strategy that is often associated with property investment, but it can be applied to any type of investment that involves borrowing to invest. The term 'negative gearing' is derived from the financial gearing ratio, which is a measure of financial leverage. In the context of negative gearing, the term 'negative' refers to the fact that the income generated by the investment is less than the expenses, resulting in a loss.

Understanding Negative Gearing

Negative gearing is a financial strategy that involves borrowing money to invest in an asset, with the expectation that the income generated by the asset will be less than the expenses associated with owning and managing the asset. The loss that is incurred can then be used to reduce the investor's taxable income, resulting in a lower tax liability.

This strategy is often used in property investment, where the investor borrows money to purchase a property, and then rents out the property. The rental income is usually less than the expenses associated with owning and managing the property, such as mortgage interest, maintenance costs, and property management fees. This results in a loss, which can be used to reduce the investor's taxable income.

Benefits of Negative Gearing

The main benefit of negative gearing is the potential for tax savings. By incurring a loss on an investment, an investor can reduce their taxable income, which can result in a lower tax liability. This can be particularly beneficial for high-income earners, who are in the higher tax brackets.

Another benefit of negative gearing is the potential for capital growth. While the income generated by the investment may be less than the expenses, the value of the investment itself may increase over time. This can result in a profit when the investment is sold, which can more than offset the losses incurred along the way.

Risks of Negative Gearing

While negative gearing can offer potential benefits, it also comes with risks. One of the main risks is that the value of the investment may not increase as expected. If the value of the investment decreases, the investor could end up making a loss when the investment is sold.

Another risk is that the income generated by the investment may not be sufficient to cover the expenses. This could result in the investor having to cover the shortfall out of their own pocket, which could put a strain on their personal finances.

How Negative Gearing Works

Negative gearing works by allowing investors to deduct the costs of owning an investment property from their overall income. This includes interest on the loan used to purchase the property, as well as other expenses such as property management fees, maintenance costs, and depreciation.

The idea is that by making a loss on the property, the investor can reduce their overall taxable income. This can result in a lower tax liability, which can make the investment more affordable in the long run.

Example of Negative Gearing

Let's say an investor purchases a property for $500,000, using a loan with an interest rate of 5%. The annual interest on the loan is $25,000. The investor also incurs other expenses, such as property management fees and maintenance costs, totalling $5,000 per year. The total annual expenses are therefore $30,000.

The property is rented out for $20,000 per year. The income from the property is therefore less than the expenses, resulting in a loss of $10,000. This loss can be deducted from the investor's taxable income, reducing their tax liability.

Negative Gearing and Tax Benefits

The tax benefits of negative gearing can be significant. By reducing their taxable income, an investor can potentially save thousands of dollars in tax. However, it's important to note that the tax benefits should not be the sole reason for choosing to negatively gear an investment.

The potential for capital growth should also be a key consideration. If the value of the investment increases over time, the investor could make a profit when the investment is sold, which could more than offset the losses incurred along the way.

Negative Gearing and Small Businesses

Negative gearing can be a useful strategy for small businesses, particularly those that are looking to expand or diversify. By borrowing to invest in assets such as property, a small business can potentially reduce its taxable income and save on tax.

However, it's important for small businesses to carefully consider the risks associated with negative gearing. If the investment does not perform as expected, the business could end up making a loss. It's therefore crucial to seek professional advice before deciding to negatively gear an investment.

Considerations for Small Businesses

When considering negative gearing, small businesses should take into account their current financial situation, as well as their future plans and goals. It's important to consider whether the business can afford to make a loss on the investment, and whether the potential tax savings will outweigh the risks.

It's also important to consider the potential impact on cash flow. If the income from the investment is not sufficient to cover the expenses, the business may need to cover the shortfall, which could put a strain on cash flow.

Seeking Professional Advice

Given the complexities and risks associated with negative gearing, it's crucial for small businesses to seek professional advice. A financial advisor or accountant can provide valuable insights and advice, helping the business to make an informed decision.

They can also help the business to understand the potential tax implications of negative gearing, and to plan and manage the investment effectively.

Conclusion

Negative gearing is a financial strategy that can offer potential benefits for small businesses, including tax savings and the potential for capital growth. However, it also comes with risks, and it's crucial to seek professional advice before deciding to negatively gear an investment.

By understanding the concept of negative gearing and how it works, small businesses can make informed decisions that align with their financial goals and objectives. Whether it's expanding the business, diversifying the investment portfolio, or reducing tax liability, negative gearing can be a powerful tool when used effectively.