A group of houses with trees and bushes. Positive vs. Negative Gearing.

Investing in real estate can be a substantial driver of wealth creation, but like any investment strategy, it requires careful consideration and understanding. Two popular strategies in property investment are positive and negative gearing. In this article, we’ll delve into the pros and cons of each, providing insights into scenarios where they might be applied, and how they influence investment decisions.

What is Gearing?

Before diving into the specifics of positive and negative gearing, it’s essential to understand the concept of gearing in real estate. Gearing refers to the borrowing of funds to purchase a property. Based on the property’s income in comparison to its expenses, gearing can be categorised as positive, negative, or neutral.

Positive Gearing

Definition: Positive gearing occurs when the income generated from a property, such as rental income, exceeds the expenses associated with owning it, including the interest on the loan, management fees, and maintenance costs.

Pros of Positive Gearing

  1. Supplementary Income: The most apparent advantage is the additional income stream. The surplus can be used for further investment, paying off the mortgage, or personal use.
  2. Lower Financial Risk: Since the property generates enough income to cover costs, there’s less risk of financial strain.
  3. Easier Loan Approval: Lenders often favor properties that are positively geared since they pose a lower risk of default.

Cons of Positive Gearing

  1. Higher Taxable Income: The extra income increases taxable income, potentially moving the investor into a higher tax bracket.
  2. Slower Capital Growth: Properties that are positively geared tend to be in lower capital growth areas, which might affect long-term wealth accumulation.

Example Scenario for Positive Gearing

An investor purchases a property in a regional area with stable rental demand. The purchase price is $300,000, and the annual rent is $20,000. The annual expenses, including mortgage interest and maintenance, total $15,000. The result is a $5,000 surplus each year.

Negative Gearing

Definition: Negative gearing occurs when the property’s income is less than the expenses, leading to a financial loss. The loss can often be used to reduce the overall tax liability.

Pros of Negative Gearing

  1. Tax Benefits: Investors can deduct the shortfall from their taxable income, potentially resulting in significant tax savings.
  2. High Capital Growth Potential: Negative gearing is commonly associated with properties in high-growth areas, offering potentially substantial capital appreciation.
  3. Portfolio Diversification: Investors can use this strategy to diversify their portfolio, balancing high-growth properties with income-generating ones.

Cons of Negative Gearing

  1. Immediate Financial Loss: Investors must be willing to absorb ongoing losses in expectation of future capital gains.
  2. Higher Financial Risk: Sustained losses can lead to cash flow issues, particularly if market conditions change or unexpected expenses arise.

Example Scenario for Negative Gearing

Consider an investor who buys a property in an up-and-coming urban neighborhood for $600,000. The annual rent is $25,000, while expenses total $35,000. The annual loss is $10,000, which the investor offsets against their income, reducing their overall tax liability.

Comparing Positive and Negative Gearing

When comparing these two strategies, it’s crucial to consider the investor’s goals:

  • Cash Flow vs. Capital Growth: Positive gearing is suitable for those who prioritize steady income, while negative gearing leans towards long-term capital gains.
  • Risk Appetite: Positive gearing entails less financial risk. In contrast, negative gearing carries higher risk but with potentially higher rewards.
  • Tax Implications: Positive gearing might increase taxable income while negative gearing can reduce it, benefiting high-income earners looking for tax deductions.

Making Informed Investment Decisions

Your choice between positive and negative gearing should align with your financial goals, risk tolerance, and current financial situation. For instance:

  • Long-term Stability Seekers: Consider positively geared properties for consistent supplemental income and reduced financial strain.
  • Capital Growth Enthusiasts: Opt for negatively geared properties in burgeoning markets for potential substantial capital appreciation.

Ultimately, a balanced approach, integrating both strategies into your portfolio, might provide a diversified and resilient investment foundation.

Conclusion

Understanding the nuances of positive and negative gearing is crucial for any serious real estate investor. By evaluating both the immediate financial circumstances and long-term goals, investors can make informed decisions that align with their personal financial objectives. Whether one leans towards positive or negative gearing, or a combination of both, depends largely on individual circumstances and investment goals. Investing wisely now can determine financial success in the future.