A property is positively geared if the rental income it generates is greater than the expenses incurred in holding it. In that case, the owner must pay the tax. If the expenses are larger than the rental income, the property is negatively geared. The owner can receive a tax refund or offset the loss against other income.
Proponents of positive gearing say they’d rather profit from an investment that generates income, even if that means sharing a slice with the taxman. Those who favour negative gearing place greater emphasis on the tax advantages and using someone else’s money to reap capital gains over time.
Most worked examples used to compare positive with negative gearing assume that you’d buy a different property if you were planning to positively gear that if you were to negatively gear the investment.
It’s often assumed that negatively geared properties generate modest rental yields and have strong prospects for capital appreciation, while positively geared properties generate higher cash flows but have less potential for capital gains.
But it’s not the property itself that determines whether it’s positively or negatively geared. It’s the way in which you finance the purchase, what expenses it incurs and how much rent you can charge. If you borrow to invest in a rental property, chances are it will be negatively geared initially, although that’s not always the case.
Profitable from the start
There are two ways to positively gear a property from the onset.
Firstly, you could select a property that has a rental yield high enough to excess the cost of the mortgage. That might be difficult to find, especially in capital cities, where average yields tend to be below 5 per cent.
The second way to positively gear is to put down a larger deposit on a house or apartment that generates an average yield. In most investment property purchases, the cost of interest on the loan is the largest expense. By minimising the mortgage size, you’re limiting the interest expense, helping the income to exceed the outgoings. The main downside of contributing a large deposit is that you have a considerable sum tied up in one single asset. You could put that money to work elsewhere.
Zoë Fielding, Financial Review Smart Investor, June 2013 issue