Negative and positive gearing

Negative and positive gearing are very popular topics, especially when we talk about residential investment. Generally speaking, if your investment is negatively geared, then from a finance perspective you’ve likely made a poor investment decision. It’s only from a tax perspective that you may actually derive some benefits. However it’s very important to understand that even if your tax circumstances allow for some generous deductions, you’re not exactly winning in terms of cash flow. Your investment very much remains loss-making in the present.

Positive gearing

We discussed gearing more generally in an earlier article ever-so-creatively titled Leverage. An investment is positively geared if the income you earn from your investment exceeds your investment’s expenses. Your income can be profits, rent, dividends etc and your expenses might include interest, maintenance costs, management costs etc. Let’s explain with an example.

Alan is one of those darned, good-for-nothing lazy millennials our parents and grandparents always complain about and has therefore been splurging weekly on “smashed avocado with crumbled feta on five-grain toasted bread at $22 a pop and more” for most of his adult life. Alan quickly realises just how popular this buttery fruit is (yes it’s a fruit) and decides to invest in an avocado farm and distributor. Alan invests $20,000 of his own money and borrows $80,000 from the bank (at 5% interest) and hands over $100,000 for 100,000 shares in “Smashed Avo P/L”. Smashed Avo P/L declares a full year dividend of 5 cents per share in that financial year, yielding Alan $5,000 in dividend income for his first year of investment ($100,000 x 5%).

Assuming Alan has no expenses other than interest, Alan’s investment is positively geared during his first year. Alan earned $5,000 in dividend income and paid $4,000 in interest expenses ($80,000 x 5%). His investment has generated more income than costs he has incurred and therefore his investment is positively geared.

Negative gearing

An investment is negatively geared if your investment’s expenses exceed the income you earn from your investment. The year was not 2020 and Alan had decided he’d earned himself a holiday so he decides to go travelling in the north of Spain. On holiday he noticed most tourists were sporting some rather unsightly footwear. He does some research and decides to invest $50,000 in a sandal manufacturer, “Birks GmbH” and acquires 50,000 shares. He uses $10,000 of his own money and borrows $40,000 from the bank (at 5% interest). Birks GmbH declares a full year dividend of 2 cents per share in that financial year, yielding Alan $1,000 in dividend income for his first year of investment ($50,000 x 2%).

Assuming Alan has no expenses other than interest, Alan’s investment is negatively geared during his first year. Alan earned $1,000 in dividend income and paid $2,000 in interest expenses ($40,000 x 5%). This time the expenses on his investment exceed the income it has generated and therefore his investment is negatively geared.

Residential investment and tax concessions

Okay let’s cut to the chase – the only type of negative gearing anyone cares about right? Alan has decided he would like to diversify his investment portfolio. He secures a loan for $800,000 (at 4% interest) and armed with a $200,000 deposit he invests $1,000,000 in a 2 bedroom, 80 square metre apartment in the trendy inner western suburbs of Sydney. Alan rents out his apartment at $800 per week (or $41,600 per year). Alan pays $14,500 in non-interest expenses (including strata fees, water and council rates and maintenance costs). He also pays $32,000 interest in his first year of investment ($800,000 x 4%). His investment is negatively geared. Why? He’s earned $41,600 in rental income in his first year of investment but he’s paid $46,500 in interest and other expenses during the same year. Why would anyone do this? Two reasons:

  1. Capital growth: You may have noticed that in each of the above examples we omitted capital growth from the equation. We assume Alan’s 100,000 shares in Smashed Avo P/L would remain valued at $100,000 and we assume Alan’s 50,000 shares in Birks GmbH would remain valued at $50,000. We omit capital growth from the examples for simplicity, and also because this article is about income rather than growth. However in the real world assets fluctuate in value. Those shares will go up or down in price and so too will his investment property. Alan hopes his $1,000,000 property will grow to $1,500,000 or $2,000,000 in the long term and he is happy to weather the short-term costs.
  2. Tax concessions: Australians earning over $180,001 in income during the FY20 financial year will pay 45 cents for every dollar they earn over this figure in income taxes. Investment expenses are usually tax-deductible and if you purchase a residential investment in your own name, any losses you make on your investment during your financial year may be deducted from taxable income. In Alan’s case, he will be able to deduct $4,900 from his taxable income at tax time (expenses less rent). Please seek your own tax advice – this is a simplified example not applicable to everyone.

How could Alan positively gear the same investment? Alan would have to either earn more than $46,500 in rent in his first year of investment or reduce his interest expenses by using a higher deposit in order to generate more income than expenses. Now Alan’s investment may be said to be positively geared, however his cash flow may still be negative. Home loans in most cases come with principal repayments as well as interest repayments. Obviously the principal repayments are beneficial as they increase Alan’s equity stake in the property but it is still money he has to finance out of pocket. If Alan truly wanted to be cash flow positive, he would have to yield high enough rental income to cover both his interest and principal repayments. Principal repayments are not tax deductible.

Opportunity cost

But wait, there’s more. You may argue that the only reason Alan’s investment in Smashed Avo P/L was positively geared is that he had invested 20% of his own money (implying that had he invested less it might be negatively geared due to having taken out a larger loan) or that his investment in Birks GmbH is only negatively geared because he had invested only 20% of his own money. Obviously the more you invest and the smaller your loan, the more likely it is your investment will be positively geared. But there is a cost to this – opportunity cost (see Economics 101).

The politics

Negative gearing for residential investment purposes is a bit of a sensitive point in politics. Left-wing politicians argue it’s a means for high income earners to avoid paying their “fair share” of taxes. Right-wing politicians argue it incentivises investment in housing. I personally on balance, argue in favour of negative gearing. It genuinely does incentivise investment in housing, the building blocks of which is an industry very significant to the local economy – the construction industry is said to generate $3 of benefits for every $1 of investment in residential housing. I also personally believe the progressive taxation system often goes too far and to tax someone who’s gone the extra mile and worked really hard to earn income over $180k, at 45 cents on the dollar is a little unjust and in my opinion, well above their “fair share”.