Definition
Negative gearing is a financial strategy used in real estate, where an investor borrows money to invest and the income generated from the investment is less than the expenses. This results in a net loss, which is often offset against other taxable income to reduce the total tax liability. This strategy is generally employed with the anticipation that the investment will appreciate in value over time, thereby yielding a profit in the long run.
Key Takeaways
- Negative Gearing refers to a financial or investment strategy where an investor purchases an income-producing asset, often a property or shares, and the income generated by the asset is less than the cost of owning and managing the asset, including depreciation and interest charged on a loan.
- The primary objective of negative gearing is to achieve capital growth. The investor anticipates that the capital gain made from selling the asset will exceed the accumulated losses incurred through holding the asset.
- Investors who use a negative gearing strategy can often offset their investment losses against their other income, reducing their overall tax liability. This aspect can make the practice attractive for high-income earners in jurisdictions that allow such tax treatment.
Importance
Negative gearing is a vital finance term primarily because it presents a strategic approach to investment, which can lead to tax advantages.
It involves borrowing money to invest in an income-producing asset, typically a property, but where the net income generated is less than the cost of owning and managing the investment, including interest charged on the loan.
This ‘negative income’ situation may seem counterintuitive, but the advantage lies in the ability to deduct this loss from other taxable income, thereby reducing the investor’s overall tax liability.
While this approach adds a layer of complexity to investment strategy, and it carries certain risks, as any investment does, under the right circumstances negative gearing can facilitate wealth accumulation over the long term.
Explanation
Negative gearing is a financial strategy often employed in the field of investment, most commonly in real estate, but also in stocks or other assets. Essentially, negative gearing occurs when the cost of owning an asset (including interest expenses, maintenance costs and other charges) exceeds the income generated from it.
The prime purpose behind this approach is to create a situation where the investor is making a loss, not a profit. This may seem counterintuitive, but the main reason an investor chooses to negatively gear an investment is due to the preferential tax treatment for investment losses.
This concept works on the principle that the net loss generated from the investment can be offset against other income earned, thereby reducing the investor’s overall taxable income. In the case of property investment, not only can the investor reduce their tax but they may also benefit in the long term if the property appreciates in value significantly over time, leading to a sizeable capital gain when the property is sold.
Examples of Negative Gearing
Negative gearing is a common financial strategy typically used in real estate investment but can apply to other types of investments as well. Here are three real-world examples:Real Estate: Suppose an investor buys a property worth $500,000 using a $100,000 down payment and a $400,000 loan with an annual interest of 5%. The property generates an annual rental income of $20,
However, the interest payable on the loan would be $20,000 plus additional costs such as management fees, maintenance costs, and taxes – let’s say an extra $5,In total, the expenses (loan interest and additional costs) are greater than the rental income, so the property is negatively geared.
Stock Market: An investor borrows money to purchase shares believing that the return on investment (through dividends and capital growth) will exceed the cost of borrowing. However, the return is lower than expected, and the investor has to pay more in interest on the loan than they are making in dividends. This scenario is an example of negative gearing in the stock market.Business Investment: A business owner might borrow money to invest in new equipment, expecting it to generate additional profit. However, if the new equipment doesn’t lead to the expected increase in revenue, but the business still needs to cover the interest costs on the borrowed funds, the business is negatively geared.
FAQs – Negative Gearing
What is Negative Gearing?
Negative gearing is a form of financial leverage where an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest expense. The investor uses the shortfall to reduce their income tax liability.
Why would someone use Negative Gearing?
The main motive behind negative gearing is that the investor expects the asset value to appreciate over time to more than compensate for the losses incurred over the borrowing period. Additionally, the tax benefits provide immediate cash flow relief.
What are the risks with Negative Gearing?
The risks associated with negative gearing are chiefly that the asset value might not appreciate as expected. This could result in the investor making a net loss even when the tax benefits are taken into consideration.
Can you give an example of Negative Gearing?
Let’s say an investor buys a rental property with a loan. If the rental income from the property is less than their interest payments on the loan, then the property is negatively geared. Essentially, they’re making a loss on the property, but they can use this loss to reduce their income tax.
Is Negative Gearing only for property investments?
No, negative gearing is not restricted to just real estate investments. It’s a financial approach that can be applied to any investment where borrowed funds are used, such as shares or bonds. However, it is most commonly associated with property investments because of the high cost of real estate, making borrowing necessary for most investors.
Related Entrepreneurship Terms
- Investment Property
- Interest Deductions
- Tax Loss
- Cash Flow
- Capital Gains
Sources for More Information
- Investopedia: This website offers a lot of financial terms and their detailed explanations, including Negative Gearing.
- The Balance: The Balance provides expertly written and fact-checked articles on finance and investing topics.
- KPMG: KPMG is a global network of professional firms providing Audit, Tax, and Advisory services. They also provide insights on various financial topics.
- PWC (PricewaterhouseCoopers): A network offering professional services and great articles on finance and financial terminologies.
