You must have heard real estate investors discuss positive gearing and negative gearing before entering the world of property investing. Continue reading this article to find out what they are if you’re still unclear.
Yes, it is crucial to educate yourself on real estate. It’s imperative to become familiar with the language used in real estate investing, especially if you’re new to this. In addition to giving, you an instance of each, I will define positive gearing and negative gearing in this blog post. I’ll contrast the two in terms of their benefits and drawbacks as well. To learn more about positive and negative gearing in real estate investing, keep reading.
It is significant to highlight that there are numerous technicalities involved, but I will make an effort to keep things easy. And by fairly straightforward, I mean that most negatively geared properties eventually become positive. Hence, there must be another motive for our property investment in a negatively geared because, in the end, we desire a passive income from both outcomes.
Nevertheless, there is a third component to investing that many observers overlook: risk. When investing in residential real estate, you can often only have two of the three factors—cash flow and capital growth—while also taking risk into account. You will have to give up significant capital growth if you want a real estate investment with minimal risk and substantial cash flow. High rental yields must typically be sacrificed if you want to make a low-risk investment with great capital growth (cash flow).
Without a question, if I had to choose between cash flow and capital growth, I would always choose to invest in capital growth. Of course, in a perfect world, I’d prefer to purchase homes with all three of these characteristics, and while this combination is conceivable, it is not typical. I’m able to accomplish all of these things by buying homes in places with rapid population expansion and adding value to them by refurbishing or doing property development into townhouses. I get high-growth properties with high yields in exchange for the additional rent and the tax benefit I obtain.
Let’s examine the negative gearing vs. positive gearing discussion since many new investors seek out homes with positive cash flows. Negative gearing has undoubtedly been a hotly disputed and discussed component of real estate investing for many years, with several proposals for reforms, adjustments, and changes to this tax mechanism over time.
But what is negative gearing exactly?
Is negative gearing a better tax technique to employ than positive gearing? How does it assist investors to maximise their profits while holding real estate assets? To help you better grasp what negative gearing and positive gearing are and how you may use them to your advantage, I’ll go into detail about both in this essay. When we refer to a property as being “geared,” we are referring to how much it costs to own the property. Property ownership can have several tax advantages, and when those advantages are taken into account, becoming a landlord may seem quite alluring. One tax provision that landlords might use to assist defray property ownership expenses is negative gearing. Let me clarify 2 things before I get too far in this comprehensive article.
A specific property is neither a favourably geared investment nor a negatively geared investment. It depends on the amount of debt you owe on that asset. If you have little to no debt secured by the investment property, even one with a very low rental return will be positively geared (generating more cash flow than it consumes).
Using negative gearing as an investment strategy is not recommended.
Now, I realise that this will confuse a few individuals, but your wealth creation situation after accounting for your expenses and the rental revenue from your property investment is a statement of your financial and leveraging strategy. Negative gearing is not a viable investing strategy on its own. As I previously mentioned, my preferred investment strategy is to purchase investment-grade properties that will appreciate over time as well as properties that will generate rising rent over time. This is because both of these factors—rising value and rising rent—will enable me to purchase additional properties that will appreciate, etc.
Hence, unlike many others who real estate investment for the cash flow, I purchase investment properties so that I may purchase further investment properties. And I’m able to do this because the increase in the value of my house provides the necessary equity and the rising rent enables me to pay off my debt. Let’s now examine how gearing functions and determine which strategy, positive gearing or negative gearing, is more advantageous over the long term.
As I previously mentioned, my preferred financial strategy is to purchase investment-grade properties that will appreciate over time as well as properties that will generate rising rent over time. This is because both of these factors—rising value and rising rent—will enable me to purchase additional properties that will appreciate, etc.
What is a property with positive cash flow?
First things first: let’s start with a property having a positive cash flow. Some real estate experts try to make positively geared properties seem mysterious and difficult to understand, but in reality, they are a straightforward concept that largely depends on how a given investment advice is financed. Positively geared properties are those where the rental income covers all costs of ownership plus more. Simply put, a property with positive cash flow produces a return greater than its cost of ownership.
Here’s an example of a $200,000 regional condo that produces $12,000 in annual gross rental return at a 6% rate.
The buyer pays a 25% down payment, or $50,000, to buy the property. For the remaining $150,000, they apply for an interest-only mortgage with a fixed rate of 3%.
6% of rental revenue equals $12,000
A mortgage with 3% interest equals $4,500.
$3,500 is equal to repairs, management, strata fees, and council rates.
AVERAGE PROFIT ($12,000) – AVERAGE COSTS ($8,000)
Annual nett cash flow before taxes: $4000
Keep in mind that this is the net cash flow; the ultimate cash flow may be adjusted to be more or less favourable for the real estate buyers depending on how income tax and depreciation are factored in.
In simple terms, this example demonstrates how a property with positive cash flow starts off returning a profit.
Advantages of investing in positively geared real estate
Positive cash flow landlords like to invest in these kinds of assets for very obvious reasons: they pay for themselves, which reduces the ongoing expense to the property owner. This is the only financial strategy chosen by some real estate buyers. After all, why would you put all of your hard-earned money in a real estate venture that will continually cost you money to maintain? As we start addressing negative gearing as it applies to real estate, we’ll get right into it, but before, some more advantages of positive gearing.
Positive cash flow properties, as previously noted, produce an immediate return, meaning you start to profit from your property investment as soon as you take possession of it. Also, you will profit from both positive cash flow and capital growth if you buy a positive cash flow home in a growth location. In other words, you will profit twice: once from the rental return and again from capital growth, which raises the value of the house or apartment each year. All of this comes from a resource that spares you the monthly hassle of digging into your pocket to cover operating costs.
The distinction between a property with positive cash flow and one that is favourably geared should be made at this point.
Regardless of your tax situation, a property investing with positive cash flow generates a positive (or surplus) return from day one. A positively geared asset may not initially pay for itself, but after deducting taxes and taking into account depreciation, the asset more than pays for itself. In either case, if you invest in a positive property, it implies you are doing so in a piece of real estate that will eventually fund itself and start paying you a profit right now.
How can I identify properties in Australia that are favourably geared?
You must purchase real estate that generates high yields if you want to be a successful positive cash flow investor. The amount of rent received, stated as a percentage, is the yield. Using the prior scenario, let’s say you are the owner of a property that cost you $200,000. Rent for the week is $230, which you get.
Weekly rent $230
Multiply by 52 weeks $12,000
Divide annual rent ($12,000) by the purchase price ($200,000) 0.06
Therefore, yield equals…
The potential drawback to the strategy of purchasing a property for good cash flow is that as a landlord, you might be forced to expand your search for a property outside of the big capital cities to remote areas. This is due to the lower yield that capital city properties often have.
You can locate properties with a greater return and yield by investing in regional areas, but the growth drivers might not be as powerful as they are in densely populated metropolitan centres. Due to the higher cost of inner-city properties—even though they are in high demand among renters—the amount of rent that is often paid each week does not cover the expense of owning the property.
Regional properties typically offer greater rental yields but historically have experienced slower capital growth rates. Of course, there may be periods when particular regional locations experience substantial capital growth, but over the long run, capital growth rates are highest in areas with high demand and limited supply. Noting that not all real estate markets are made equal is also crucial.
Certain capital city markets don’t perform as well as others, while some regional markets offer very significant returns and capital growth. This is why it’s crucial to conduct thorough research before you purchase a property with positive cash flow. Some investors have had the bad experience of investing in a property with positive cash flow and only receiving modest cash flow returns each year. Over time, people come to realise that the value of the property has increased very little, if at all, and that it would have been far better to put their money towards another type of property or asset class.
What does the term “negative gearing” mean?
Australians have been using negative gearing as a tax tactic for years, if not decades, to make the notion of owning investment properties more bearable and rewarding. Australians have been using negative gearing as a tax tactic for years, if not decades, to make the notion of owning investment properties more bearable and rewarding. Negative gearing, to put it simply, is when you hold an asset—in this case, a piece of real estate—that costs you more to maintain than it generates in income. For instance, your mortgage interest payment and all other property-related expenses are greater than the revenue or rent you receive from that property.
In this case, a higher rate taxpayer invested $750,000 on a two-bedroom apartment in the capital city that yields 3%.
Since they put down 10%, the mortgage’s interest rate is now only 3%.
Income from rentals: 3% yield $19,500
Mortgage at 3% interest equals $20,250.
8,000 dollars for repairs, management, strata fees, council rates, etc.
While this was going on, the rental income from this property would likewise increase significantly along with its capital growth, eventually catching up to the rental income from the first (high-return) property.
Capital growth vs rental income on a $500,000 purchase
7 per cent capital growth 4 per cent rental return on property value 5 per cent capital growth 7 per cent rental return on property value
Year 1 $535,000 $21,600 $525,000 $36,750
Year 5 $701,276 $29,387 $638,141 $44,670
Year 10 $983,576 $43,178 $814,447 $57,011
Year 15 $1,379,516 $63,443 $1,039,464 $72,762
Year 20 $1,934,842 $93,219 $1,326,649 $92,865
An Explanation of negative gearing in Australia
Many nations, notably Australia and New Zealand, allow the deductibility of negative gearing losses on the property against income from other sources. The Australian Tax Office (ATO) enables real estate buyers to offset several property-related expenses from their regular income tax. In the aforementioned case, the landlord would incur the following costs each year:
Mortgage interest $20,250
Repairs and expenses $7,000
Depreciation* $9,000
Total costs = $36,250
Total income = $19,500
OVERALL LOSS OF $17,250
So, $17,250 is the difference between the landlord’s on-paper expenses and income, which can be offset by the property owner’s income tax after the fiscal year.
How the Tax Office will assist you in overcoming the continuous cash flow problem
Even though you anticipate receiving a sizable tax return at the end of the year, paying the cash gap on a negatively geared property during the year could be a strain. Nevertheless, there is a way the taxman can assist you in doing this. The Tax Act contains a modification option that allows you to arrange to have less tax withheld from your paycheck as soon as you buy your property.
Significant advantages of negative gearing
Negatively geared real estate investments have several advantages, especially for long-term investors like property owners. There are various advantages for the larger society as well as the above-mentioned personal tax advantages. They consist of the following:
Constructing lodging for the community at large
Negatively geared investors help those who can’t afford to buy homes by supporting the private rental market, which lowers the demand for public housing provided by the government. There would be a national housing catastrophe if it weren’t for the over 30% of Australians who rent from private landlords.
Boost the need for construction
The building sector is supported by investor demand for real estate, particularly in light of the favourable changes made to the negative gearing laws for new properties. This promotes the creation and maintenance of jobs. According to estimates, more than a million Australians work in the real estate industry.
Individual financial accountability
The tax advantages of negative gearing encourage people to save and invest, especially to support their ability to support themselves in retirement. Long-term, this lessens the government’s financial burden. In terms of the investor personally, a negatively geared investment property will typically continue that way for several years, but will typically change due to rising rent returns.
This implies that your negatively geared investment will eventually turn positive when the rents rise. You currently have a capital growth asset that is self-funding and helping you accumulate wealth for your future, so you are getting the best of both worlds.
Which is better, negative or positive gearing?
The fact regarding positive versus negative gearing is that there is no “better” technique, as unpleasant as that may be to read. Your particular situation will determine whether a negative or positive investment approach will be successful for you. Eventually, based on a person’s income, tax situation, and ambitions, various investment plans necessitate various techniques. We might be able to locate an excellent quality real estate investment opportunity priced at $700,000 with a $500 rental yield.
Based on Investor A’s specific income tax rate, savings, risk tolerance, and goals, investment advice might be a very good fit for him. But Investor B, who has a different spending limit, schedule for investing, and risk tolerance, might find this particular property to be wholly inappropriate. Does this imply that the $700,000 property investment we made in our home was a “poor” one? Not! It means that each property investor in Australia must base their investment choices on their particular situation and objectives. Using the $700,000 property from the aforementioned example, it can be situated on a sizable corner lot that is ideal for development. Investor A plans to split and partition the block and sell the land component after holding it for a few years while making aggressive debt payments.
The finest time to purchase a property was twenty years ago, according to a proverb. Today is the next ideal time.
What is keeping you from taking the following step if you have been thinking about becoming a landlord?
