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What is the difference between negative gearing and positive gearing? When you purchase an investment property, you will need to know the difference. Negative gearing can be beneficial to some, but you also need to consider positive gearing. This guide will help you decide which is best for your circumstances.
Negative gearing explained
When you purchase an investment property, you may receive less rent than your expenses. In this case, your property is negatively geared.
For example, you purchase a property for $500,000, but only receive $450 per week in rent. Between your loan repayments, property management fees and repairs, you spend an average of $2000 a month on the property. Since you are only receiving $1800 a month in rent, you property is negatively geared.
Positive gearing explained
You’ve found an investment property for $400,000. It’s in good condition and needs little maintenance. You rent the property for a healthy $500 a week, but your monthly expenses are only around $1800 a month. The extra $200 you make on the investment property means the property is positively geared.
It may seem like having a positively geared property is better than negative gearing, but you need to consider everything before making that decision. There are benefits to negative gearing and drawbacks to positive gearing. It may be to your benefit to have a negatively geared property. Of course, it will depend on your personal financial circumstances, but it’s worth considering negative gearing.
Benefits of negative gearing
How could taking a loss on an investment property have positive benefits? Think beyond having a positive cash flow from your property to some of the benefits of negative gearing. For one thing, the income you make is taxable. If you have a negatively geared property, you can reduce your tax burden by claiming many deductions from the property. What can you claim back on an investment property at tax time? outlines the expenses you can claim.
Keep in mind that the expenses you can claim at tax time may not offset your losses. For example, if you have yearly losses of $9000, you might only be able to claim $3000 on your taxes. That reduces the losses to $6000, but you need to have $9000 to cover the ongoing costs.
That’s one benefit of negative gearing, but it can be offset by possible negative consequences. Negative gearing is a long-term strategy based on the assumption an investment property will increase in value over time.
There are also potential disadvantages to negative gearing. The main disadvantage is that you need to know you can manage the costs of a negatively geared property into the indefinite future. The financial risk can be high. For example, how would you keep up with the payments if you lost your job?
Income protection insurance can help you get over the hump in a situation like that. Income protection insurance can be relatively inexpensive, but it will depend on your age, occupation and other factors. It also depends on your salary. If you make $3000 per month, the cost will be about half of what you would pay if you make $6000 per month.
Of course, income protection insurance is another expense. Before choosing a negatively geared property, consider all the possible expenses and make a decision on your ability to keep up with all your payments.
Benefits of positive gearing
Positive gearing sounds like the ideal way to invest in property. It gives you a positive cash flow and in time, the investment property will be more valuable. That is certainly one benefit of positive gearing.
Another benefit of positive gearing is that lenders will look more favourably on lending money for a positively geared property. Not only will a lender be willing to lend money for a single investment property, they may be willing to lend money for subsequent properties if you decide to purchase another property.
Another benefit of positive gearing is less risk if you lose your job. The property pays for itself and you won’t have to make a “panic sale” if you are without income for a period of time. This can work to your advantage because property prices rise and fall. You want to be able to time your sale for the greatest advantage.
The disadvantage of positive gearing is that your income is taxable. Put aside the taxable income and it won’t be a problem. If you make a positive cash flow of $1000 per month, you will have $12,000 in extra income. Ask an accountant to calculate how much of that to set aside. It may be 30% or more. If you need to set aside 35% of the income, it amounts to $4200. If you’ve set the money aside, you won’t need to scrape together the money at tax time and will still have $7800 in income for repairs to the property or for property management fees.
Negative gearing vs positive gearing
What is the best choice? It really depends on your personal circumstances. Before you purchase an investment property, add up all the costs involved in the transaction. These will include upfront fees when you find a lender. You may need to pay some legal fees and advice fees. It’s important to understand the regulations regarding property investment. Getting sound advice from an expert is a good idea.
Other unavoidable costs will include stamp duty and bank fees. It’s also a good idea to use a property management service. Assuming you have a job, a property management service can help keep tenants happy and take care of repairs, rental collection and other details for you. Leasi has fixed rates that are lower than other property management fees, so you always know how much you have to pay per month. See our Fair Pricing guide to find out more.
One of the highest fees may be stamp duty. Depending on the state or territory you live in, stamp duty can range from $13,500 to $24,000 on a $500,000 purchase. The other costs won’t be insignificant, either. Subtract the upfront costs from your savings to determine how much you have for a deposit.
The next step is to determine your monthly outgoings. Do you make enough money to cover the costs of negative gearing? You should be able to do this comfortably, keeping in mind you may need extra money for property repairs and maintenance. If your income is enough to cover your expenses, negative gearing can work for you.
As mentioned above, positive gearing can work, but you need to plan ahead and set aside taxable income on the property. In most cases, coming up with an extra $3000 or $4000 at tax time can be difficult, but if you set the money aside, you will have it at tax time. You will also have money to cover many expenses.
Positive gearing is considered the safest type of property investment, but negative gearing can work, too. Just be sure you can cover the expenses and purchase a property that grows in value over time.
Whether you purchase an investment property through negative or positive gearing, one thing you don’t want is to have a vacant property to pay for. How to reduce the risk of vacancy explains how to buy a property that will attract tenants and what you should do when a tenant vacates a property. Keeping a property in good repair will attract better tenants and longer term tenants.
Buying an investment property is not an easy decision. Do your sums and find the right property. If you take the time to make the right choices, either negative gearing or positive gearing can work for you.