“Negative gearing” is one of those terms that many property investors use but do not really understand. Other investors may see negative gearing as a smart strategy to reduce their tax bill. New investors are often confused between the apparent conflict between the obvious benefits of being “cashflow positive” and the dubious benefits of being “negatively geared”. Which is best? Can they be both at the same time? And what is negative gearing – really?

Negative gearing is simply borrowing to make an investment to the extent that the investment makes a loss.

Let’s step back a bit and recap on “Accounting for Property 101”. Rent received is taxable income. Against the rent received the property investor is able to claim certain cash expenses such as rates, insurance, mortgage interest, rental management fees, accounting fees etc. (Anyone wanting a full list of deductible rental property expenses is welcome to email us and we’ll send you a comprehensive list of tax-deductible expenses).

The cash rent received less the cash expenses paid is what we call the “cash profit or loss”. (The cash profit or loss is calculated before paying mortgage principal repayments.)

However, in addition to the cash expenses paid we are also able to claim depreciation. Depreciation is in effect a “paper loss” or the diminution in value of the assets employed to earn taxable income. We all know that carpet in a rental property will wear out and need to be replaced at some point. The IRD allow property investors to depreciate the carpet (and the building, improvements and other chattels) by a certain amount each year, which roughly equates to the number of years each item is expected to last before it needs to be replaced.

So after taking the “paper loss” or depreciation on the building, improvements and other chattels off the cash profit or loss we will have a final figure that we pay tax on. If that final tax figure is a negative the owner of the property is likely to receive a tax refund or tax reduction (assuming they have other taxable income) at their nominal tax rate.

Let’s work through some examples:

Example “A” is cash flow positive before and after tax.
Example “B” is cash flow neutral before tax and cash flow positive after tax.
Example “C” is cash flow negative (negatively geared) before tax and cash flow neutral after tax.
Example “D” is cash flow negative (negatively geared) before and after tax.

Examples “C” and “D” can only move the investor ahead if the property is increasing in value. In example “D” unless the property is increasing in value by more than $1,730 each year the investor will be going backwards financially.

While we normally expect property to increase in value it does not do so consistently year in and year out. Our example “D” investor may make capital gains some years and none (or even reduction in capital value) in subsequent years.

Some people would say that investor “D” is a speculator rather than an investor. Investor “D” is speculating that prices will move ahead by more than the losses he/she is incurring to hold the property.

Investor “D” is also limited in the number of properties he/she can own because investor “D” will have a finite amount of cash to invest. However, theoretically investors “A”, “B” and “C” are unlimited in the number of properties they can invest in (so long as a bank will lend them money!)

Investor “D” is playing a riskier game than investors “A”, “B” and “C”.

Investment is about adopting a personal strategy that suits your personal situation. All four investing examples may win or lose, depending on how they play their game and what the market does.

Morale of the story… negative gearing is a riskier game. Before embarking ensure you can afford to play. It generally better suits high net worth individuals in the top tax bracket (39%) who can afford short/medium term cash losses in exchange for long term capital gains. If that is not you, then negative gearing is not such a great idea.