To negative gear or not to negative gear? Even Shakespeare had his opinions

William Shakespeare may have penned the line “To be, or not to be, that is the question.” For professional accountants, the (arguably) equally profound question we are commonly asked is, “To negative gear or not to negative gear?”

Most investors have a basic understanding of what negative gearing is and how synonymous it is with property investing. This article will expand upon these concepts by discussing positive gearing, non-property investment assets, and the differences between cash flow and tax position.

Positive versus negative gearing

The term “gearing” refers to the use of leverage, otherwise known as a loan, with which to fund an investment acquisition. Interest costs incurred on monies borrowed for investment purposes are tax deductible, so it is often seen as an attractive option in reducing tax.

Negative gearing is, in essence, a tax deduction created due to expenses incurred in owning the investment (with interest costs typically being one of the larger expenses) exceeding the income earned from the investment.

A simple example to illustrate:
$20,000 income received
$25,000 expenses incurred
————————————-
$5,000 negative gearing loss
————————————-

Positive gearing, by contrast, occurs when investment income received exceeds the expenses incurred, with the resulting profit more usually being taxable.

To illustrate:
$25,000 income received
$20,000 expenses incurred
————————————-
$5,000 positive geared profit
————————————-

Why is negative gearing so popular?

The reason negative gearing is so prevalent with property investors is twofold.

First, the sheer cost of buying the property itself would frequently be completely unattainable without a mortgage.

Second, it is to do with the differential between interest rates and rental yield. A bank may charge 6-8 per cent p.a. as the interest rate but the gross rental yield (which is the yearly rent received as a percentage of the property’s market value) may be between 3-5 per cent p.a. and this is before other ownership costs (such as rates, levies, insurance etc.) are factored in, inevitably creating a loss position.

So why then would an investor be happy to lose money via such a strategy?

A key driving force, dare it be said, is taxation. The tax deduction brought on by negative gearing is directly correlated to how much income tax someone needs to pay.

A taxpayer earning above the top marginal tax rate of 47 per cent will therefore save (such as via an additional tax refund) 47 per cent of their negative gearing loss.

To quantify this, a $10,000 negative gearing deduction equates to $4,700 tax saving. By extrapolation, a $50,000 negative gearing deduction will generate $23,500 in income tax savings.

The higher someone’s taxable income, thereby their marginal tax rate, the greater the tax benefit that can be obtained.

The other driving force behind why investors opt to implement a negative gearing strategy is capital appreciation. Put simply, the investor anticipates the investment growing in value.

To illustrate, let’s assume a property investor buys a $500,000 property and sells it 10 years later for $1,000,000. Transaction costs to buy and sell may be $50,000, thereby the investor has made a pre-tax profit of $450,000 (i.e. $1,000,000 – $500,000 – $50,000).

If $10,000 of negative gearing losses arose each year for 10 years, then over the life of the property $100,000 (i.e. $10,000 x 10) of negative gearing losses have been derived. So, a $100,000 “cost” led to a $450,000 profit.

Gearing into non-property investment asset classes

The term “margin loan” is a strategy of being able to leverage, or gear, into shares.

In recent times it has become increasingly common for share investors to utilise their residential mortgage to fund share investments owing to the advantages of lower interest rates as well as removing the risk of margin calls brought about by adverse price volatility.

Investors can either positive or negative gear into shares/managed funds/ETFs and will do so for the same reasons as property, that being to reduce tax and for the investments owned to increase in value.

Certain shares also have the added tax benefit of what is known as franking credits, or imputation credits, which can enhance the investors’ after-tax rate of return.

It is also possible to borrow money at one interest rate and invest it at another. This strategy is colloquially known as “playing the margin”.

To illustrate:
$100,000 invested at 10% p.a. = $10,000 interest income
$100,000 borrowed at 7% p.a. = $7,000 interest expense
————————————-
$3,000 profit
————————————-

There is no (or perhaps very little) capital appreciation when investigating in higher yielding fixed interest type securities, and accordingly this approach to investing will inevitably be positively geared.

Cash flow versus tax

In the world of investing, it is common that there will be differences between what the investor physically receives as income and pays as expenses, compared to the numbers reported within their income tax return.

Of particular relevance when it comes to borrowing money to invest are the mortgage repayments themselves. Loans can be classified as either “interest only” or “principal and interest”.

Principal and interest repayments will be higher due to having to pay down a part of the remaining loan balance with each payment. While the principal component will affect cashflow, it will not affect someone’s tax position, as it is only the interest component that is tax deductible.

Investment in real estate may have added tax deductions such as depreciation and building write-offs. Investments in dividend paying shares may, as stated above, benefit from franking credits.

To be or not to be (leveraged)?

It can certainly be financially advantageous to be able to borrow money to invest. Any decision to use leverage to invest needs to be weighed up carefully against the risks.

Interest rates can and will change. Economies will prosper as well as enter recessions. Wars will break out, pandemics will occur, and changes in economic policy and tax laws by different governments of the day are all inevitable.

The use of leverage to gear into investments most certainly has the potential to improve an investor’s rate of return. But all coins have two sides; an unsuccessful investment can magnify your losses and leave you servicing a loan for many years after the investment has been sold or wound up.

Receiving sound investment advice in addition to quality taxation advice before entering any gearing strategy would be wise.

As Shakespeare’s Sir John Falstaff says in The Merry Wives of Windsor, “Money is a soldier, and will (work) on.”

In 1602, that was his way of saying “money is a good soldier to have in your corner and you should be putting it to work for you.”

It’s probably as true now as it was more than 400 years ago.