Investing in property has been a stable way of generating a second income for many Australians. However, the real estate industry is filled with technical jargon that often deters potential investors from entering the market.
When researching property investing, you have likely come across the term negative gearing, but not many people consider its counterpart: positive gearing. In this blog post, Joust breaks down what you need to know about positive gearing so that you can have a well-informed investment strategy when buying property.
What is Positive Gearing
Positive gearing occurs when you consistently profit from your property investment, meaning that your rental income is higher than property costs.
Property expenses can include any of the following:
- Property maintenance costs
- Mortgage interest repayments
- Property management fees
- Real estate agent fees
- Council rates
- Insurance premiums
- Gas and electricity
- Body corporate fees
- Legal expenses
How Positive Gearing Works
With the understanding that positively geared investments generate a higher rental return than property expenses, it's essential to understand how this investment strategy works. Investing in positively geared properties is considered a low-risk strategy, as you have a constant surplus that you can use for enduring unexpected jumps in interest rates or other expenses.
However, unlike negatively geared property, this strategy has no tax deduction incentives to entice investors. Therefore, the Australian Taxation Office (ATO) considers any net profit that you earn from your positively geared property investment as taxable income.
Consequently, while positively geared investment properties are technically safer, you will need to pay tax on any money you generate on rental returns.
Positive Gearing vs Positive Cash Flow Investment
Despite common belief, positive cash flow property is not positive gearing. The key difference is that positive cash flow investments generate a profit after tax.
Commonly, cash flow properties do not generate income before tax, therefore running at a loss. However, you can recoup these losses on your tax return thanks to government benefits and deductions. Thus, turning your loss into profit following tax.
This is different to positively geared property, as this investment generates a profit before tax. Therefore, this requires a different investment strategy and should be treated separately to positively geared properties.
How to Find Positive Gearing Property
Positively geared properties can be challenging to find, as they require specific market conditions with slow capital growth, low property prices and high rental demand. Generally, you can find these market conditions within regional areas of Australia.
However, buying a negatively geared property does not mean that it cannot change. Over time, you may experience that your investment property becomes positively geared.
This can happen in instances where:
- You pay off your home loan faster by making extra mortgage repayments.
- Your bank drops interest ranks on your home loans.
- Your rental yield increases.
If you find yourself in such conditions that could positively gear your property, you should consider how this will influence your investment strategy by assessing potential benefits and limitations.
Pros and Cons of Positively Geared Property
To form the best property investment strategy, it is critical to understand the advantages and disadvantages of positive gearing. Property investors should consider how the following points benefit or limit them based on their financial circumstances and personal goals.
Benefits of Positive Gearing
Positive gearing offers a range of advantages that could benefit your investment strategy.
This includes:
- Extra income: You can use your rental income to further improve your financial position without being out of pocket. For example, you can use excess cash to make additional mortgage repayments, helping you pay off your home loan faster.
- Diverse investment portfolio: A positively geared property can help balance your portfolio by using the extra cash flow to offset losses from negatively geared investments.
- Increased financial security: Additional income from your rental property can partially protect you during an unexpected change in circumstances. For example, if you suddenly lose your primary income stream, you have the security of your rental income.
- Increased Trustworthiness with Lenders: Having a second income can increase your attractiveness to a credit provider, making it easier to secure finances for other investments.
Limitations of Positive Gearing
However, positive gearing does have some limitations that could potentially disrupt your ability to generate wealth on your investment.
This includes:
- No tax benefits: The rental income generated from your positively geared investment properties is considered as taxable income by the ATO. Therefore, this will reduce the total amount generated on your property.
- Minimal capital growth potential: As positively geared properties are typically located in regional areas, they may have fewer capital growth opportunities than investments in cities.
- Hard to find: Finding positively geared property with investment potential can be challenging and requires extensive market research.
Positive Gearing Tax Implications
The ATO requires you to declare any income generated from rental properties when completing your tax return.
Types of income that you need to declare include:
- Bonds
- Letting/booking fees upon cancellations (especially for holiday homes).
- Payouts from insurers, including natural disasters or unexpected events that cause a loss of rent.
- Relief money received from a charitable fund.
- Money received from tenants to cover repair expenses on property damage.
- Money received for buying a depreciating asset.
- Lump-sum rental payments.
- Amounts linked to debt arrangements involving your rental property.
However, you can reduce the overall amount owed to the ATO by claiming tax deductions on your property. Deductions are expenses that minimise the amount of your taxable income.
Fortunately, there are various tax deductions that you can claim on your positively geared property, including interest on loan repayments, rental expenses and insurance premiums. Check out our property tax guide for more information on other deductions you can claim with the ATO. Alternatively, speak to an experienced tax accountant for tax advice to help you save money.
Positive Gearing Example
For further clarification, here's an example of how positive gearing works.
Jennifer has just purchased a $500,000 investment property in a region with strong rental demand. Consequently, Jennifer can charge her tenants $800 rent per week, generating a steady rental income.
After assessing her property expenses, Jennifer realises that her weekly rental income exceeds her costs by $200 per week. Therefore, as Jennifer generates an income before tax, her property is positively geared.
However, at the end of the financial year, Jennifer must declare her total rental income accumulated on her tax return. While she can reduce this amount with deductions, she will still need to pay tax on her income.
Considerations Before Investing in Positively Geared Property
If you're still unsure about positively gearing an investment property, consider the following points:
- Are there significant expenses tied to the investment? Take into account all the expenses associated with the property to determine if you will be generating a decent amount of rental income.
- How much tax will I pay on my rental income? Your total amount payable will depend on what tax bracket you're in; for more information, check out this resource from the ATO.
- Is there potential for capital growth? Do your research on the region where you're thinking of purchasing and see the price rates. Are they declining, rising or staying the same?
- Can I financially handle changes in interest rates? Interest rates can fluctuate, rising and falling depending on various factors.
- Does the property align with my investment strategy? Ask yourself about your financial goals. Are you committed to having this property as a short or long-term investment? How will capital growth help you maximise your earnings if it is long-term?
Ultimately, by asking yourself these questions, you can help weigh up your options and decide if a positively geared property is right for you.
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Negative Gearing vs Positive Gearing
Negative gearing occurs when the expenses of your investment property are more than the rental return, therefore running at a loss.
People use negatively geared properties as an investment strategy, as it helps reduce your total taxable income each year. However, you will need some form of cash flow to offset the short-term losses on your negatively geared investment property.
Is Negative Gearing Better than Positive Gearing?
While positive gearing offers low-risk opportunities for property investors, it can be hard to find. Therefore, negatively geared property tends to be more popular for investors, as wider city regions have more opportunities.
Furthermore, negative gearing also offers more potential for capital growth and, therefore, could be more profitable. This, combined with tax benefits, makes negatively geared properties an attractive investment option.
However, negative gearing carries more risk as an investment option than positive gearing. Therefore, you will need to ensure that you have a certain level of financial security that will help compensate for the short-term losses from your investment property.
What’s the Best Option For My Investment Property?
Both positive and negative gearing has benefits as well as limitations. Consequently, you will need to assess your financial circumstances and personal goals before researching the specific investment property you want.
For example, if you have all your cash tied up in other assets, you may want to consider a positively geared property to create some cash flow and offset other investment losses. However, if you have an abundance of disposable income, negative gearing may be a suitable investment option as you can afford the temporary out of pocket expenses.
A good starting point is to seek independent financial advice to help you organise your assets and determine the best investment strategy to maximise your wealth.
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