Negative Gearing Investment Property Explained

Aspiring and established property investors build a property portfolio by purchasing residential or commercial properties, with the intention of leasing it out to renters to earn money from it. To enable them to buy such a property, they take out an investment property loan for which they need a deposit of at least 20% of the value of the property.

When the expected profit on their properties turns into losses, property investors in Australia have been utilising negative gearing. With the government’s changes to tax brackets and marginal tax rates in July 2024, it seems that negative gearing may become less attractive as it may cause an increase in rents and house prices.

Understanding Negative Gearing

The term gearing, refers to taking out a home loan in order to buy a property, but when the costs of owning and maintaining the rental property begins to exceed the rental income the property generates, it is referred to as negative gearing.

How negative gearing works in Australia
Negative gearing can apply to all types of investments, but when, for example, investment property owners operate at a loss they are able to deduct their losses from their taxable income, such as salaries and wages.

Benefits of negative gearing for property investors
Because property investors are able to offset their costs related to their property against their taxable income, if their property is rented out or it is available for rent, they can claim the interest on their loan repayments as a tax deduction.

Potential risks and downsides
Although property investors are able to deduct their losses on their investment property from their taxable income, they could still operate at a loss. Holding on to such an investment property or asset for years in the hope of making back the money they lost, they would have to pay capital gains tax on any gains when they eventually decide to sell it.

Investment Property Home Loans

Definition and types of investment property home loans

When an investor takes out a home loan to buy a property with the purpose of renting it out for financial return, it is called an investment property home loan  The full loan term is usually 30 years, but the buyer has a choice of two options.

The first loan option is an interest-only investment loan which is usually between three and five years, and during that time the borrower only have to pay the interest on their loan. However, at the end of that period, their repayments will include the principal as well as the interest. This gives the borrower the benefit of only paying interest for the first few years, but thereafter they will pay a considerable amount more for the remaining period of 25 to 27 years.

The second option is a principal and interest home loan where the purchaser pay the principal amount they borrowed, as well as interest, from the start. In this way they will pay an increasing part of the payment on the principal amount while a decreasing amount will go towards the interest they are paying.

Comparison between investment property loans and owner-occupied home loans

Firstly, the key difference between these two loans is what the buyer intends to do with the property. If they are planning to rent it out, it is considered an investment, but if they are planning to live in it, it is called an owner-occupied property.

Secondly, the interest rates tend to be more on an investment loan because lenders view it as a higher risk, and therefore this loan will also involve additional closing costs.

Key features and benefits of investment property loans.

Apart from paying a higher interest rate on an investment property loan, there is also the risk the that property will need repairs from time to time or that the owner may find themselves in a position where there is a gap between tenants.

An investment property is one of the best investment opportunities out there as financing is extremely accessible. It is also more flexible than other investments as the purchases has the option to flip it later on, should they wish or need to do so.

The Relationship Between Negative Gearing and Investment Property Home Loans

How negative gearing can impact the decision to take an investment property loan:

Negative gearing can provide a solution to a property investor whose expenses on their investment property begins to exceed its rental income, even if it makes a loss year after year. A well-located property’s value will likely rise in time and produce capital gain. The annual loss can be offset against other income, such as salary or wages.

It is however not guaranteed to make money, but rather a solution to help the investor save on tax. There is also no guarantee that any losses will be compensated by future capital gains, or when they eventually decide to rather sell it.

Tax implications and benefits of combining negative gearing with investment property loans:

The tax implications of negative gearing with investment property loans are significant. Investors can use the resulting net loss to offset their other taxable income, potentially reducing their overall tax liability. This means that if an investor's property is negatively geared, they can claim the loss as a deduction against their wages or other income, which can lead to substantial tax savings.

However, it's important to consider that while negative gearing can offer tax benefits, it also entails financial risks, particularly if property values fall or rental incomes do not meet expectations. Additionally, the Australian government periodically reviews tax policies, so it's crucial for investors to stay informed about any changes that might affect their tax situation.

Advantages and Disadvantages of Negative Gearing

Negative gearing in Australia offers significant tax benefits and potential for long-term gains, making it an attractive strategy for many investors. However, it also involves risks such as short-term financial strain, market volatility, and regulatory changes. Investors should carefully assess their financial situation, risk tolerance, and market conditions before pursuing this strategy.

Advantages:

Tax Benefits:

Apart from deducting losses from a negatively geared property from an investor's other income which reduces their taxable income and results in lower tax payments, high-income earners also benefit significantly from the immediate tax deductions, which can make the investment more affordable in the short term.

Long-Term Investment Potential:

• Australian real estate has historically appreciated over time therefore it potentially offers substantial capital gains when the property is sold.

• As property values rise, the investor's equity increases, providing more financial leverage and opportunities for further investment.

• Over time, rental income can increase, potentially turning a negatively geared property into a positively geared one, enhancing cash flow and overall returns.

Disadvantages:

Ongoing Costs: Investors must cover the shortfall between rental income and property expenses, which can strain finances, especially if the property doesn't appreciate as expected.

Market Risks: Real estate markets can be volatile due to fluctuations in property values. Should property values decline, the anticipated capital gains may not materialise, leading to financial losses.

Rental Market Dependence: Relying on rental income growth can be risky. Economic downturns or a gap between tenants can lead to lower-than-expected rental income.

Regulatory Risks: Government policies and tax regulations can change, potentially reducing the benefits of negative gearing. For example, limits on deductibility or changes to capital gains tax concessions could impact returns.

Recent changes in government policies affecting negative gearing and investment property loans

Recent changes in Australian government policies affecting negative gearing and investment property loans include increased scrutiny on lending practices and tighter regulations. The Australian Prudential Regulation Authority (APRA) has implemented stricter lending criteria to ensure financial stability, including limits on interest-only loans and tighter assessments of borrowers' ability to repay loans.

While proposed changes to restrict negative gearing to new properties were not implemented after the 2019 election, the current government continues to monitor the housing market and lending practices to address affordability and stability concerns.

Predictions and expert opinions on the future of negative gearing in Australia

Expert predictions and opinions on negative gearing in Australia suggest a potential shift in policy focus. They foresee renewed discussions on reforming negative gearing to address housing affordability and market imbalances.

The ongoing pressure to make housing more accessible could lead to proposals that limit tax benefits for investment properties or restrict negative gearing to new constructions only. Some analysts believe that while substantial changes might be unlikely in the short term, incremental adjustments could occur, reflecting concerns about rental affordability and market stability.

The future of negative gearing will likely hinge on political will and economic conditions, with debates likely focusing on balancing investor incentives with measures to enhance housing supply and affordability. The evolution of these policies will be crucial in shaping the investment landscape and addressing broader housing market challenges.

Practical Tips for Investors

Choosing the right investment property loan

An investment property loan is a long-term commitment. Considering possible changes in the interest rate and the property market, choosing the right investment property loan is not something to be taken lightly or rushed into.

Ask yourself what you want to achieve with this property and which investment property loan will help you to achieve that. Refer to Investment property home loans in this article to better understand the different options available to you.

Advice on managing risks associated with negative gearing

In this case prevention is better than cure, or, planning and strategizing is better than experiencing financial loss in the long run. Here are some tips to consider before renting out your investment property:

• Choosing your investment property wisely and using a mortgage advisor to ensure that you get the best available interest rate.

• While considering rental laws in Australia, as well as location, property size and amenities, ensure that there is a large enough gap between the monthly rental and the repayment amount for the investment property loan.

• To save on costs property investors should consider managing the rental property themselves, eliminating the costs involved when using a real estate agent or property manager.

• Ensure that you and your rental property is well insured to cover unforeseen circumstances.

 
Strategies for maximizing the benefits of negative gearing:

Negative gearing in itself is actually a key investment strategy, but betting on the future value and potential for long-term capital growth of the investment property that will be purchased is equally important.

Rental yield and capital growth are the two avenues where your rental return comes from. Begin to take control of your investment by understanding rental yield, which measures the profit generated from your investment (the gap between the annual rent and the rates, maintenance and other expenses). This will help you determine the value and potential of your property.

Conclusion

Even though there are many misconceptions and myths around negative gearing, for example, that it is only available to the wealthy or that it inflates property prices, or promotes new housing supply, it has provided a solution to property investors for many years in that they don’t only have to depend on tenants’ rent for profit.

Lastly, property investors have to manage their property and their income well, and adequately insure their investment and themselves against any unforeseen circumstances.

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