Is positive gearing better than negative gearing?

The only method to really increase your wealth from a property and/or to actually become financially independent is through capital growth.

For higher-income earners in particular, tax benefits (negative gearing) are a highly potent side benefit; however, the two concepts should not be confused.

Otherwise, you can end up investing in the wrong property and wasting your time and money.

To help you better understand these gearing techniques, I will compare the two approaches, using examples of how each investment works, as well as highlight the primary pros and disadvantages, and how they might operate within an investing strategy.

What is a positively geared property?

When you borrow money to invest, positive gearing is used since the income from your investment exceeds your interest and other costs.

You will still be able to keep the extra cash, but you will also be responsible for paying taxes on the greater net income.

Positively geared investments boost your earnings and may eventually result in a capital gain if the value of your investment rises.

When you earn more in rental revenue from your renters than you spend on things like loan repayments, interest, property maintenance, management fees, rates, etc., this is known as positive gearing.

This frequently occurs when interest rates are low and rentals are high due to a high demand for rental properties.

The term "cash flow property" can also be used to describe an investment that is positively geared. The reason for this is that the property will put extra money in your pocket.

How does it work?

Let's use a $400,000 investment property as an example, located in a neighborhood where there is a significant demand for rental properties.

You charge tenants $500 per week in rent for the right to occupy the home. Let's now assume that the property's weekly ownership costs reach $410 in total. In this case, the property has already paid for itself because it increased your revenue by $90 a week.

The property is positively geared in this instance!

The Advantages of Positive Gearing

Increased income - You gain from the property's income and avoid having to pay out of pocket. You may even utilize this money to increase your mortgage payments and get your house sooner!

Less risk - If your financial situation changes, such as if you lose your work, the income will cover the costs of the investment, decreasing the likelihood that you will need to sell under duress and possibly unfavorable circumstances.

Balanced portfolio - Some investors might utilize a positively geared asset to even out their portfolio, using the extra cash flow to cover the shortfall from negatively geared investments.

Lender Attractiveness - Your appeal to lenders for new loans may increase as a result of the greater income.

The Disadvantages of Positive Gearing

Taxable - The income you receive from a positively geared property is taxable, just like any other type of income.

Slower long-term growth - A positive cash flow investment can frequently (but not always) be found outside of capital cities, in a region that typically (but not always) experiences slower or lower capital growth.

May be more volatile - These characteristics could be highly reliant on a specific industry of employment, making them more volatile should employment factors deteriorate.

What is a negatively geared property?

When you borrow money to invest, negative gearing is used since the return on the investment is lower than the outgoing costs.

For instance, you are essentially making a loss if you borrow money to purchase a house and the rental revenue is less than the interest and other costs.

Your investment will be negatively geared if you borrow money to buy shares and the dividends from the shares are less than the loan's interest.

Negative gearing is a well-liked method of minimizing tax, but keep in mind that you can only do so if you decrease your taxable income.

Negative gearing has tax advantages, but you need also take into account the impact on your after-tax income.

You may be prepared to accept ongoing losses if you expect to have a capital gain in the future when the value of the investment increases.

There is no guarantee this will happen, and in the meantime, you'll have to cover the shortfall from other income. If interest rates rise, you'll be out of pocket even more.

Negative gearing occurs when the rental income you receive is less than the total costs involved in owning that investment property.

Often referred to as 'capital growth properties', negatively geared investments are expected to appreciate (grow) in value over time, and this increase is expected to outweigh any short-term financial losses.

These properties are commonly located in areas closer to capital cities which typically perform better over the long term.

How does it work?

As an example, let's imagine you purchase an investment property for $440,000. The property is located in high growth, a stable area where properties are renting for a more affordable amount due to higher availability of rental properties in the area.

You rent the property to tenants for a rental return of $425 per week.

Let's assume the combined costs for your property totals $440 per week. Therefore, after all, expenses - the rental income for this property does not fully cover repayment costs, and you have a shortfall of -$15 per week.

In this situation, the property is negatively geared.

The Advantages of Negative Gearing

Tax Deductions - 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 shortfall and ultimately reduce your taxable income.

Capital Growth - 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 the sale.

More affordable for tenants - Because of the affordability, it can be easier to secure a tenant for the long term.

Less volatile - Unlike property in a regional area which may rely heavily on particular employment industries to drive up demand, these properties rely on a variety of factors and can be a less volatile investment.

The Disadvantages of Negative Gearing

Budgeting may be needed - You may need to be able to budget for the ongoing shortfalls, also, when the property is sold for a profit, the tax man collects on the capital gain.

Long-term strategy - It's a long term wealth-creating strategy, so if your circumstances change and a sale is necessary, the sums may not work out favourably.

Higher financial risk - If in the instance, you were to lose your job, you will need to be able to maintain any costs involved. Make sure you have a plan in place to ensure you are prepared—for example, income protection and insurance policies.

Why would I invest in something that is losing money?

I say to anyone out there who is serious about investing in property, and it's crazy to invest purely for a negative outcome or a tax outcome.

That's just naive, but you will see a lot of investment advisors talking about all the depreciation that you might be getting and focus on that as an investment strategy.

That's just dumb. We don't want to do that. Let me give you an example:

Let's say we go and buy a business and the business worth $500,000. We are attracted by the fact that we are going to save from a tax point of view, so we are going to run at a loss for ten years on the assumption that the business is going to worth a million dollar in 10 years time.

Now, the reality is, not every property is suitable for investment, so you see a lot of people talking about attractive off the plan apartments, house and land packages with really large depreciation components but they are just in the wrong location.

So they run this business for 10 years, and it doesn't grow in value, and they have been getting all these accumulated losses, but they have yet to see any capital growth.

So you should always invest for growth as opposed to negative gearing or tax benefits. Tax benefits are purely a fringe benefit associated with that, and some properties have excellent growth.

The reason why they are negatively geared is that the growth in the value of the property and the area expansion in terms of the need and desire for people to get in there is what pushes the value higher. So rents are lagging.

They actually have to catch up to try to get that type of outcome. So when we're talking to our clients and advising them, we're actually talking about a growth strategy and looking at location, primarily and then looking at the local neighbourhood and then looking at the property whether it stacks up.

If it is negatively geared at that point and it has got some depreciation, that's a bonus as opposed to just going for tax benefits. It's crazy to think that you'll get a $10,000 tax benefit, but you are going to lose $30,000 – $50,000 over 5-10 years. That's not smart. So that's negative gearing.

From a positively gearing point of view, we are talking about wow, if this property is going to deliver us returns on a month-to-month basis, why don't we just always go for positively geared if it means it doesn't affect the family budget or the household budget, why wouldn't just keep chasing more and more of these positively geared properties.

Now, the argument for that is you will need to accumulate quite a lot of them. In reality, positively geared properties have limited growth opportunities.

So the growth story is a timing story where if you can pick the right time to get into the market, then you might see a bit of growth. But you got to ask yourself this question: Why is the property positively geared?

In other words, why is tenant willing to pay more to rent the property than actually to own it? Because in reality, their rents would be the same as their repayments.

This is down to the story, well, you need to test the area. People don't want to live there, or is it a low social, economic area? When in reality, there are people who are just comfortable in renting, and they don't know any better, we call them the non-aspirers.

They are just going to keep going to rent properties. Well, they don't get a good income, and they don't get good income growth.

So the area struggles for that growth story. The other areas where you find a positively geared property is in regional towns or mining centres which have boom and bust cycles. So you've got to be prepared for low growth and the challenges of turnover in terms of tenants.

The capital growth story over here with negatively geared properties is one of the more stable, more reliable, more structured properties in great locations as opposed to the cash flow positive story over here which is we've got to be ready for some bumps in the road and some timing issues around the performance of growth.

It's just going to outperform on a growth story than what the negatively geared property is going to do.

So let's wrap that up—a couple of key messages. You chase properties for growth, or you chase properties for income. The fact they are negatively geared or cash flow positive and the tax story is a supplementary story. If you are just chasing that tax story, you are going to be sold a lemon.

That's my big message here. Won't be buying these well-tantalised, well-presented, well-marketed properties on the mass. Sit down, do your sums, do your numbers and do your research. It could mean that you are better off buying an existing property over a new property.

On a cash flow positive side, it is going to be a story of making sure and being willing to understand that your tenants aren't necessarily going to be great reliable tenants and making sure your property managers are doing a great job looking after it.

So the story is, make sure that you understand those things and from an investment point of view, look at your own household and cash flows. If you've got strong cash flows, then we would talk about a growth story.

If you've got less in the bank in terms of surplus cash flow, then we might talk about a yield story or an income story, and it's a combination of those two as you build your own property portfolio that is going to give you a passive income for life.

Negative gearing is, in effect, a cash flow outcome, as a federal tax policy allows investors to claim their investment losses against their taxable income.

Positive gearing really just means that the rent you receive is more than the cost of all the property expenses each month. So you're making an "income" from it.

When a property is positively geared, it means you don't need to top up your mortgage each month – and so it could be argued that it is faster to accumulate more properties this way – as it can be easier to save money to generate a new deposit for your next property purchase.

Most positively geared properties are, however, in less 'desirable' areas – with a lower property cost entry point – areas with a lower socio-economic population – such as fringe, or regional areas – where often the capital growth will be lower.

It's better for your cash-flow, but usually not as strong in terms of capital growth.

So, in this case, as a serious investor, it's important to save and invest your positive cash-flow to make up for the usually lower growth in property value.

Investors buying in more 'desirable' – higher entry point, areas – would expect that their rental yield will be lower, so the rent received for these properties won't cover the mortgage and other expenses – but that the capital growth over time would be higher and thus exceed any outlay that they had during the time they held the property.

So they need to 'top-up' their mortgage repayments each month, to save on tax at the end of each tax year.

For example, an investor might receive $10,000 a year in rental returns but pay $25,000 a year in interest on their loan. If they are earning $100,000 a year, then the negative gearing tax policy allows them to reduce their taxable income in this scenario to $85,000 a year, which can mean a big tax refund.

Negative gearing works differently and means a different cash flow outcome for everyone – depending on your tax bracket and the age of the property.

What do you want to achieve?

It can sometimes be hard to see the big picture when it comes to property investing, especially if you're new to the game.

Generally speaking, a sustainable portfolio is all about balance. If you have some negatively geared properties in your portfolio, aim to balance it out with positively geared properties to offset the losses.

Overall, it's important to surround yourself with experts, including a financial adviser and a mortgage broker, as well as learn and form ties with people who have gone down the investment path before you.

There's a lot of noise out there, but eventually, you'll learn to find the sweet spot in the level of risk you're willing to bear and what to choose when it comes to negative gearing vs positive gearing.