Gearing your property for positive results

If you're thinking about investing in property for the first time you'll need to consider if you want a negatively or positively geared investment.

When it comes to positive or negative gearing an investment property, factors such as your income, borrowing capacity, financial goals and time frames and the level of risk you are comfortable with are all considerations.

Why you're investing will help you make this decision but to set realistic expectations you'll need to be up to speed on the positives and negatives of each.

Positive and negative gearing explained

There are basically two ways you can make money through property investment; through income returns or capital gain.

When your investment income is greater than your investment expenses you'll have positive income returns - this is a positively geared property.

Properties that return less rental income than the costs of owning the property are negatively geared. They're expected to appreciate in value over time and are often called 'capital growth properties'. This investment strategy relies on the property increasing in value over time to outweigh any short-term financial losses.

Pro's to positively gearing your investment property

A positively geared investment exists when the rental income you receive is higher than the expenses for the property. This type of investment is often referred to as a 'cash flow property' as the property is putting additional money into your pocket.

Obviously if you're looking for more immediate returns then a positively geared investment may be more suitable for you.

If your income were to change this investment is also lower in risk. As long as the property is tenanted the rental income will cover the investment costs.

Like any additional income, a positively geared investment can increase your attractiveness to lenders if you were to apply for additional loans.

Down the track you may want to use a positively geared property to balance your portfolio. You can use the additional income to pay the shortfall of negatively geared investments.

The Pros

  • Increase your income
  • Not as much risk if your income circumstances changes
  • Are used by some investors to balance a portfolio by using the additional income to pay the shortfall of negatively geared investments
  • The additional income can increase your attractiveness to lenders for additional loans

Some things to consider about positive gearing

Whilst this investment will supplement your income remember it's taxable. It's smart to put a small amount aside each month to ensure tax time isn't stressful.

Positive gearing is usually a short term strategy but might not make a big difference to your lifestyle or financial position. Often positively geared investments are located in regional areas and may return high rental income because of mining or infrastructure activity. This can cause (but not always) less or slower capital growth.

The Cons

  • The income you earn on a positively geared property is taxable
  • Often positive cash flow investments are located in regional areas (rather than capital cities), which commonly (but not always) see less or slower capital growth

Negatively gearing isn't a bad thing

A negatively geared investment exists when the rental income you receive is less than the costs of owning the property. Often referred to as 'capital growth properties', negatively geared investments are expected to appreciate in value over time, and that this increase will outweigh any short-term financial losses.

The payoff comes when you sell if the property has produced above average increases in value over the long term.

Investing in capital growth property is a long term approach and should form part of a broader wealth strategy. Down the track this may involve using the equity in your property to purchase another. To do this you'll need a property that is increasing in value over time which is why a property with high potential for capital growth is necessary.

You can also claim tax deductions relating to any expenses you incur on an investment property. So an advantage to negative gearing is in using this loss of income to reduce the amount of tax on your other earnings.

The pros

  • A big pro and a common reason investors choose this strategy, is that it allows you to claim tax deductions related to the expenses you incur so by claiming the available tax deductions, you can reduce your rental profit and ultimately reduce your taxable income
  • Assuming the strategy goes to plan, the capital returns from the property will eventually outweigh the borrowing levels and costs to create wealth for the investor at sale

Things to remember about negative gearing

Negative gearing relies on the eventual sale providing the returns so you need to be comfortable with putting money in long term. It's a good idea to build some equity early on so that if your income were to change, such as losing your job, you'd still be able to meet your repayments.

The cons

  • You need to be able to budget for the ongoing shortfalls
  • When the property is sold for a profit, the tax man collects on the capital gain
  • Some property experts argue that investors who use tax breaks to own properties are willing to pay more for purchases, pushing up prices and negatively impacting affordability for first home buyers
  • It's a longer term wealth creating strategy so if your circumstances change and a sale is necessary the sums may not work out favourably if the market is flat (i.e. you need the right conditions for sale to ensure the eventual profits outweigh the expenses)

Can you get the best of both worlds?

A positively geared property usually won't be a high capital growth property because of it's location. To get the best of both worlds you should look at ways to increase your rental returns on your high growth properties. For example, by renovating your property you can increase your rental income and your depreciation allowances.

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