There – I said it! Negative gearing is all about losing money – it involves debt and high risk yet I’m almost certain that many readers will have never heard it described so bluntly.
When was the last time you heard anyone point this out? The promoters of negatively geared investment strategies (into property and/or shares for example) have much to gain from encouraging people to negatively gear so you won’t always receive the full story from parties who have a vested interest. So let’s look in detail at negative gearing: What is it? When is appropriate and what type of investors is it suitable for?
Gearing is a proxy term for ‘borrowing’ – it’s as simple as that. You might sometimes see the term ‘leveraged investing’ wherein ‘leveraged’ also simply means borrowing.
Gearing, like how gears on a bicycle enable the rider to get over very steep hills, enables an investor to buy a larger investment(s) than their financial position would otherwise allow. Similarly, like a ‘lever’ can enable the movement of large objects with much less human effort, so too does leveraged investing permit a larger investment(s) to be purchased than might otherwise be possible.
Gearing – leveraging – call it what you like but the bottom line is that involves borrowing money.
This is where money is lost. The negative in ‘negative gearing’ applies wherever the costs of servicing the investment such as loan interest, professional fees, investment maintenance (repairs etc.) exceed the income being generated by the investment(s). In other words, the investor has to spend more to hold the investment than what the income received from it amounts to.
“Yes – but at least I can get a tax deduction!”
True, but as I once heard it stated quite simply: “That’s like spending a dollar to save 50 cents.” And note that, under current Australian tax law, a deduction is permissible wherever the asset is Australian based and produces taxable income. The deduction applies only to the amount of costs (interest etc.) which exceeds the income received from the investment.
So why would anyone ever negatively gear an investment(s)?
This is the key point – such an investment strategy only makes financial sense if there is a likelihood that the value of the investment(s) will increase over time. And it is time which is a key determinant in whether or not a profit can actually be made from the strategy.
While waiting for the value of the investment(s) to increase, under a negatively geared investment strategy, an investor is losing money on the cash flow – i.e. the costs exceed the income less any tax deduction which might be available. As such, the longer it takes for an investment to increase in value the higher the accumulating cash flow losses (negative).
So if asset values are being pushed higher quickly during say high economic growth or high inflation periods, the more quickly a negatively geared investment strategy becomes profitable – capital growth exceeds the losses being made on the cash flow.
Who does it suit and when is it best to do it?
Primarily negative gearing is most suitable for investors in the highest income tax bracket. This is because the tax deduction they can receive is at a higher level than someone on the lowest tax bracket, for example. This just means they have less out of pocket costs in meeting the expenses of the strategy.
Periods of high economic growth and/or high inflation are generally more beneficial for negatively geared strategies simply because asset values increase more quickly at such times.
Note however that, for around twenty years, Australia has had quite low inflation and economic growth, despite the resources boom of recent years, is currently modest.
What’s the risk?
There’s more than one risk but suffice to say the list of risks includes: loan interest rate rises – loss of employment income required to cover the ‘out of pocket’ costs (investment costs – investment income + tax deduction = out of pocket costs) – prolonged injury or sickness of the investor (out of pocket costs) – slow investment value growth – declines in investment values – slow economic growth – low inflation – a future government might cancel the tax benefits …
Investors don’t have to gear negatively – it is possible in some situations to have a neutral gearing position or even a positively geared investment(s) and I’ll explain these strategies in my next blog.
IMPORTANT – THIS IS NOT INVESTMENT ADVICE
This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary. This is a general discussion about some aspects of investing and cannot account for all circumstances.