It’s not uncommon for investors to jump into an investment without considering whether the type of return it’s offering is the right one for their personal financial situation and wealth creation goals. I learnt this the hard way early in my investment journey and it took me years to get back on track!
According to ATO data, the majority of property investors investing in negatively geared property fall within the lower tax brackets. Given negative gearing is a tax minimisation strategy first and foremost, are these investors really on the right path?
What is negative cash flow property?
In a nutshell, negative cash flow property or ‘negative gearing’ is defined as when the interest and holding costs you are paying on your investment property are greater than the rental income you receive.
The appeal of negative gearing is that it allows you to deduct the losses you have made on the property from your annual personal income (under current tax legislation), thereby reducing your taxable income and the prescribed tax you’re required to pay on that income.
Frequently the subject of much debate, negative gearing was introduced to encourage investment in property with the idea that this would increase the supply of rental accommodation throughout the country. Whether it has been successful in doing so is debatable but the advantages of negative gearing from a tax minimisation perspective cannot be denied.
What many investors don’t fully understand though is that the tax savings rarely cover the cash flow losses, leaving you with less cash in your pocket each year.
The underlying investment case for negative gearing is based on the premise that each year the property will have grown in value, which provides the return. With a long-term outlook, over time gradual rental increases will eventually see a negative property reach a stage of neutral and then positive gearing. However, it’s important to remember that capital growth year on year is not guaranteed and your return is only fully realised when the property is sold.
Who benefits most from negative gearing?
Investors who typically gain the most from negative gearing are high-income earners – those in the higher tax brackets are best placed to maximise the tax benefits. Further, higher earners can afford to have less cash in their pocket every year and are generally content with taking a long-term approach to building assets through capital growth. Their long-term goals may be to turn their negative properties positive for retirement cash flow, create a portfolio of family assets, or to liquidate and pocket the profit.
Lower-income earners considering negative gearing should investigate the pros and cons carefully to determine what benefits negative gearing will really provide. After all, investing is about the return, and until you sell the property, the return is not realised. You will need to weigh up whether you’re better off having that extra cash in your pocket each year – rather than waiting for a capital return that may not bear the fruits you had hoped for.
What is neutral and positive cash flow property?
In contrast to negative cash flow property, neutral or positive property doesn’t leave you out of pocket.
A neutral cash flow property means the property is making neither a profit nor a loss each year because the loss is balanced out by the rental income. Hopefully the property is generating capital gains, and it will likely become a positive cash flow property if rents rise and/or interest rates fall.
A positive property is one that generates an annual profit because the rental income exceeds the property’s annual holding costs. Tax will be payable on the profit but can be minimised by maximising your eligible deductions such as depreciation.
Who benefits most from positive gearing?
Positively geared property can be advantageous for most investors. The extra income stream can replace or supplement your salary, allow you to retire early, improve your lifestyle etc. It can be particularly beneficial for those on lower incomes who are looking to replace their current salary, or that of their partner’s, so that they can give up work to focus on family or other interests. It’s also a good strategy for building a portfolio quickly – the profit from your positive property can be used to invest in another.
Finding property that is positively geared from day one can be challenging as it’s often limited to regional areas.
Many believe that by investing in positive property from the outset they are forgoing capital growth. While it’s true that in many positive property markets, rental yields are high and capital growth is slow, this is not a definitive pattern. Plenty of investors achieve both by making well-researched and informed investment decisions and selecting strong-performing positive locations around the country.
Can a negative property turn positive, and vice versa?
As touched on above, a property that was originally negatively geared can turn positive if it’s a long-term investment. Over time, rents will rise, interest rates may drop or you may pay down some or all of the principal (thereby reducing or cutting your payments).
Eventually, the rental income will become equal to or greater than the costs of holding the property – turning it neutral or positive. This is often the long-term strategy of negative gearers who see it as a retirement plan – an asset that will provide them with cash flow during retirement.
Unfortunately, the opposite is also true. A property that was originally positively geared can turn negative in the event of a rental market shift and/or interest rate rise. Both cases typically need to be quite extreme to put a property into the red – it’s more likely that your profit will decrease rather than disappear. This, of course, is not ideal either.
Investors – whether positively or negatively geared – are encouraged to plan for these situations to minimise the impact if they are faced with one. With some simple preparation, ie. ensuring you have emergency funds put away, you will be well positioned to ride out tough market conditions.
Should I invest in negative and positive property?
Portfolio diversification is very important for risk reduction. Many investors find that a balance of negative and positive properties gives them exposure to a range of markets and won’t leave them with a cash flow problem. Investing in well-located negative and high-returning positive properties is an ideal overall strategy for achieving the best of both worlds – growth and passive income.
Ryan Crawford, Smart Property Investment, 2nd October 2014