This post focuses on risks associated with negative gearing and how buyer agents can help mitigate some of the potential downside, particularly in light of current property market conditions. Core to any sound long term investment strategy, it is essential to borrow within your means, as one key concern with negative gearing (that is often at times brushed over in articles) is that it not only magnifies potential gains but also loses. The more you borrow the greater your risk appetite has to become.
Quick Recap of what negative gearing is when dealing with property.
Property is negatively geared when the costs of owning it exceed the income it produces . That is to say interest on the loan, bank charges, maintenance, repairs and capital depreciation exceeds rental income.
Negative gearing is a form of financial leveraging and used as a tax efficient investment strategy, with the investor borrowing money to buy an investment property. Where the investor gets a benefit that can be used as an investment advantage is via a tax deduction on the excess costs of owning the investment property (depending on the numbers working obviously). It is important to keep in mind a negative gearing strategy will only put you in the money should the investment property value appreciate enough to cover the shortfall between rental income and property investment expenses. The investor will have to cover the shortfall till the asset is sold or the property becomes positively geared i.e. rental income exceeds property investment expenses.
Quick Risk Summary of Negative Gearing
For Negative gearing to work to your financial benefit, you need for the property value to increase. This typical means you need to go into the investment with at least a medium to long term view. Even if you sell the property at purchase price you will miss recouping the prior cash shortfalls. REIA research indicates that over the past 20 years residential prices have increased on an annual average of over 5%. However it has also been estimated that the 2008 US sub-prime lending crisis left 30% of mortgagees with a loan balance higher than their property value, so circumstances can change.
- It is essential you have the capabilities to meet shortfall payments, with these outflows typically higher than yearly paper based estimates depending on your tax refund/payment schedules.
- You should also ensure you don’t overextend yourself and ensure you have the financial capacity to allow for the possibility of interest rate increases, rental decreases, rental vacancy periods and maintenance costs.
- Purchasing an investment property purely on the basis of receiving a tax benefit is not a great investment strategy.
- General income changes can also pose a risk to a negative gearing strategy with it typically benefiting those on higher wage brackets (increased tax brackets) so you need to account for salary, bonus changes as well as sickness and injury. Many risks in reduction of income can be covered by insurance, which should be on the top of any property purchasers list.
Tax benefits form part of the decision making process as to whether to purchase an investment property but should not be the sole driver, with the quality of the investment being the most important factor in any strategy, this is where buyers agents can add real value for you. A Buyers’ agent should be able to help you identify areas that have the most potential for capital growth, as well as assist you with details around rental returns and vacancy rates.
Positive gearing is something I will cover in more depth in the future however it is worth noting that a lot of articles indicate (disturbingly) that you can’t purchase an investment property that provides positive cash flow and value appreciation. This is a fallacy, however I will acknowledge they are difficult to find, and far and few between.
Article kindly contributed by David Tomlins
Buyers’ Agent Guide