What is Negative Gearing and Why you Should Avoid It
I love this topic not because I love Negative Gearing but because this is the question that started my search for Financial Freedom. On my second visit to see my financial adviser about 3 years ago; we were talking about my financial goals and the fact that I wanted to invest in property. My financial adviser asked me “do you know what negative gearing is?” I kind of scratched my head and then he explained to me. It didn’t make any sense to me!
So What is Negative Gearing?
Negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not initially cover the interest on the loan (interest > income) – as defined on Wikipedia. In a few countries the strategy is motivated by taxation systems that permit deduction of losses against taxed income, and tax capital gains at a lower rate.
Does this make sense to you?
So you are borrowing money to make a loss intentionally. You pray and hope the property goes up in value. In most cases, over the long period of time the property does go up in value; no arguments there. But why would you lose money every month? So the banks can make money. Have you seen the quarterly profits announced by the major banks? Don’t even get me started. You withdraw cash from another banks ATM, you get charged. Your account goes in negative by a $1 by a minor error or ignorance, you get charged. Now a days, if you ask for a printed bank statement, wait, you guessed it!
Anyway, Back to our Topic of Negative Gearing…
This negative gearing concept is widely accepted in countries like Australia, Canada & New Zealand where the rental income does not cover the property expenses. I know the Americans are having a good laugh at this point! So we Aussies are definitely at the wrong end of the stick. Kiwis included too. (That’s New Zealanders by the way and no pun intended)
A major Bank in Australia in its website says – Negative gearing is an option you may want to consider if you have money to invest. What the??? Have a guess which bank this is and leave a comment below!
In America, the majority of properties are positively geared. They produce positive cash flow. That’s right, they put money in your pocket every month. In Australia 99% of properties are negatively geared which means you have to put money out of your pocket for the privilege of owning the property. Now you can find positive cash flow properties in Australia in mining towns or student accommodations to name a few. They are not that common or lucrative investments. Take student accommodations as an example – they produce positive cash flow but do not go up in value as much. In other words, there is no great growth or appreciation.
Why do People Invest in Negatively Geared Property?
Great question, by the way. Two words tax benefits. You see the governments can’t provide all the housing that is required. They need investors to fill in the gap. To entice investors into providing housing, the government allows you to write off the loss in owning a rental property against your other income like wages. That’s great you may say. Hold on! You do understand that wages are earned income and that gets taxed at the highest rate, right? If not then read my article on Passive Income which details the three types of income.
Let’s say you are in a 30% tax bracket. The government or tax office will give you a credit of 30 cents for every $1 you lose. That’s right read that again! You lose 70 cents to gain 30 cents. Where in the world does this make sense? Now I ask you, who benefits from Negative Gearing? The government, the tax office, the banks and the people who are renting. The poor investor who bought the property is not on that list, so think again!
Negative Gearing is Negative, Why?
- You lose money out-of-pocket each month
- If property values don’t go up, you are left holding the baby on your own
- Unexpected major repairs or maintenance expenses is just another nail in the coffin
- You cannot keep accumulating negatively geared properties, sooner or later you will go under water unlike cash flow positive properties
- Dependency on the tax law. What happens if the tax laws are changed in a year’s time and you are no longer allowed to get a tax credit for negatively geared properties?
- Last but not least, you have to keep earning or going to work to fund the negative cash flow each month. Where is the Financial Freedom in this you ask? Great question.
I am not saying people are not making money with negative gearing. In fact, some investors are doing really well. They either have a wealth of knowledge, experience or an awesome bank account or two. They most likely have a business of some sort to back them up as well.
If you want to be Financially Independent, then you have to ask why negative gearing? Does it make sense? If you are new to investing why not start with something positive? Have you heard someone saying I am going to work to pay off my car loan? That’s the worst you could do. Similarly reckless investing in negatively geared property can put you in the same boat. Don’t follow the herd and be in a situation where the tail wags the dog!
If reading and learning about positive cash flowing property sounds interesting to you then stick around. I learn a ton and I promise to share my learning’s! Thanks for reading. Take care and oh, be careful when taking advice from financial advisers they traditionally don’t like you to invest in property. The question not to ask is should I invest in property but rather what type of property should I invest in?