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I hear a lot about people saying they negatively gear their investment property, etc. I recently asked a PF&M question which included a note about negatively gearing.

Can somone please explain

  • What things can be negatively geared?
  • Why we would do it?
  • Some examples of how people do this?

Cheers!

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2 Answers

Here is an article that explains this: http://finance.ninemsn.com.au/pfproperty/investing/8123730/negative-gearing-explained.

In essence, it is an investment set up to produce near-term losses for tax purposes by means of borrowing without positive cash flow. The investor hopes that despite operating at a loss, the property will appreciate in the long run (and long-term capital appreciation is typically taxed at a lower rate than current income).

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This sounds mechanically like over-leveraging yourself in the housing market, like so many people did a few years ago, except that you're declaring upfront that it's an investment property and you can afford to take the losses. Am I right? Part of the reason I see this connection is because the example in the article is an investment rental property, but I'd think the financial principles would be the same. –  jprete Aug 19 '11 at 20:54
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Basically there are 2 ways you can make money from an investment, through income (eg: rent or dividends) and through the price of the investment going up (capital growth or gains).

Most people associate negative gearing with investment properties but it can be done with shares and other investments where you borrow money to buy the investment and it produces an income of some sort. If the investment does not produce an income then you cannot negative gear it.

Using a property as an example (in Australia), if all your expenses each month (loan interest payments, council and water rates, insurance and/or strata, advertising and management fees, depreciation, and maintenance expense) are greater than your income (rent), then you are negative gearing the investment property. This is a monthly loss on your investment which can be used to offset and reduce the amount of tax you pay during the year. So most people negative gearing an investment property will get a nice sum back when they do their tax returns.

The problem with negative gearing is that you have to lose money in order to save some tax. So as an example, if you are on a marginal tax rate of 30%, for every $1 you lose from the investment property you will save 30c in tax. If your marginal tax rate is 45% then will save 45c in tax for every $1 lost on the investment property. Thus negative gearing becomes more tax effective the higher your income (and tax bracket). But you are still losing money overall.

The problem is that most novice investors buy an investment property for the main purpose of reducing their taxes. This can be dangerous because the main reason to buy any investment should be that you consider it to be a good investment, not to save you tax. Because if the investment is not a good one, then you will not only lose money on the income side but also on the capital side.

Negative gearing should be looked at as a bonus or additional benefit when chosing a good investment to buy, not as the reason to buy the investment.

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