Most rental property owners in Australia turn to negative gearing as an investment strategy – but some question whether this approach is sustainable or not. Experts weigh in on when this strategy might work and when it poses great risks.

Negative gearing happens when the rental return generated by a property is less than the interest repayments and other property-related expenses.

As seasoned property investor Simon Buckingham explains: “If the total of the mortgage repayments, plus the costs of managing and maintaining the property, is more than the rent being paid by your tenant, then you’ll make a cash flow loss from the property. In other words, it costs you money to hold the property, and you must come up with the shortfall between the rent and the ongoing costs out of your own pocket.”

Negative gearing comes with its own set of pros and cons, and depending on the long-term goal, it may be the right investment strategy for some.

Negative gearing is a good idea if…

1. Saving money on tax is the priority.

A negatively geared property can reduce a person’s taxable income. Among the tax-deductible expenses are mortgage interest, council, rates, property management fees, and insurance. These deductions can help investors offset some of the losses against their income that they incur from the property.

But there’s a caveat says Buckingham. “It’s important to recognise that the deduction for the loss will only reduce an investor’s tax bill by a portion of the loss amount, equivalent to the marginal tax rate – at most 47% of the loss, including Medicare Levy, and possibly much less. So, if your property is negatively geared, chances are you’ll still be out of pocket even after any tax refund.”

Ed Chan, founder of accounting firm Chan & Naylor, adds that only the interest of the loan and not the principal is tax deductible because when a borrower first receives the loan from a lender, the money is not taxed.

“You do not pay tax on that principal when you first receive it. So, when you pay the principal back in a lump sum, or you pay it by a monthly amount, you cannot claim that as a tax deduction,” he says. “You generally only get a tax deduction if it is taxed on the other side so, you can’t have it both ways. If you receive the money and the tax department taxed you on that, then the repayment of it will then be tax deductible.”

2. An increase in property or rental value is expected.

Negative gearing can be a sound investment strategy if the future is pointing to a rise in property and rental values – but this entails a longer wait.

“An investor taking a long-term approach may be willing to accept a cash flow loss today, in anticipation of a larger capital gain in the future,” Buckingham says. “Ultimately, they hope to make more in capital growth than they will lose in out-of-pocket costs. However, this carries a degree of risk, as the immediate cash flow loss is a certainty, while the future capital gain is only a possibility.”

3. An investor’s disposable income is enough to cover losses from the property.

Negative gearing can work for investors who are earning a decent wage that allows them to hold on to the property and pay for the losses without sinking deeper into debt or going bankrupt.

Having excess disposable income to afford the negatively geared property can enable investors to hold on to a property long enough for it go up in value.

Negative gearing is a bad idea if…

1. There are no signs of an increase in property and rental values.

As Buckingham mentioned, waiting for future capital gains is tremendously risky as there is a possibility that it may not come.

Add this to the uncertainty surrounding the property market brought about by the coronavirus pandemic and the risks are amplified.

“The general uncertainty will linger for some time as the economy moves to recovery mode,” says Greg Bader, chief executive officer at rental property website Rent.com.au. “This will create downward pressure on house prices, both sales and rentals.”

Buckingham says that several factors should be taken into consideration if one expects capital growth to happen.

“Careful selection of the property and location are therefore very important if they are to maximise the likelihood that capital growth over time will not only exceed the net holding costs but also deliver a decent profit,” he says.

2. The plan is to expand your portfolio.

“If you want to build a sustainable portfolio, having a negatively geared portfolio and claiming the difference on tax is not a sound strategy, despite its popularity in Australia,” says Lloyd Edge, director and founder of Aus Property Professionals.

“You will need to build up from that by purchasing other properties that have a clear purpose and their own strategy to achieve that long-term goal and acquire financial freedom at the same time,” he says.

Buckingham adds that owning negatively geared properties decreases an investor’s borrowing capacity, which can hinder their plans of acquiring other properties.

“Lenders focus on your ability to actually repay your debt and will become increasingly nervous as more and more of your income is committed to servicing debt on investment properties,” he says. “A negatively geared property is generally a financial burden while you own it, and the bank certainly won’t lend against the potential capital gain that you say you’re going to make 20 years from now!

“This makes it increasingly difficult to get finance approval and an inability to obtain finance can stop your investing dead.”

3. The goal is to invest for passive income and build wealth.

Edge says that for investment properties to flourish, investors need to have a clear vision of where they are heading and a sound plan to make that vision come to fruition.

“What is not going to work for you is merely buying a property in one location and waiting for growth,” he says. “You need to create equity in properties and create cashflow to achieve your goals, rather than sinking all of your investment money into a single property that offers no substantial financial reward for years to come.

“You need to understand how each property will get you into the next property – this means the locations, prices and property structures will greatly differ for each investment.”

Buckingham adds that it is important to keep in mind that the purpose of investing is to create profit.

“If your primary motivation for investing is to save tax by making a negative gearing loss, then you may have missed the point,” he says.

Buckingham lists several ways on how investors can increase a property’s value.

“Strategies better suited to today’s market include investing for positive cash flow (the exact opposite of negative gearing); adding value through renovation, subdivision or property development to effectively create your own capital growth; or simply being smart about selecting areas that are primed for growth in the near term, rather than investing randomly and hoping the value of your property will go up faster than what it costs to hold over the uncertain longer term,” he says.