The pros and cons of negative gearing: DPN's Sam Khalil

Negative gearing is a contentious subject. Owner-occupiers often resent it, many organisations have called for it to be abolished and it doesn’t always work for all investors.

So what are the pros and cons and what do you need to know as an investor?
 
Firstly it depends on your investment needs and ambitions. If you’re looking for a short-term investment where the capital growth will accumulate quickly and you can get high rental returns then negative gearing probably won’t work for you.
 
If you’re an Australian working overseas and looking to invest back home then negative gearing probably won’t make a lot of sense either. This is because if the bulk of your income is being earned offshore and you’re being taxed in the country you’re working in, then you won’t stand to get the tax breaks that the government offers through negative gearing.
 
Negative gearing itself has been decried as giving an unfair advantage to investors. The Australian Council for Social Services recently suggested that it hurts owner occupiers who aren’t given similar tax breaks. However there are clear benefits to the overall market through negative gearing.
 
Specifically negative gearing helps the rental market and also keeps the overall property marketing ticking along – driving up prices and keeping it buoyant.
 
Investors need to keep rentals low so they can effectively negatively gear. This in turn creates equitable and affordable properties for people to rent.
Back in 1985 the then Labor government under Bob Hawke abolished negative gearing only to bring it back in 1987.  During that two year period, rents increased drastically across Melbourne, Brisbane and Sydney. 

In Sydney rentals skyrocketed by over 50%. So there’s a clear correlation between negative gearing and affordable housing. Nor does it only help wealthy investors, as some assert. Figures show that 80 percent of those claiming negative gearing earn less than $80 000 per year.
 
So while there are many benefits to the property market, what do you need to consider if you’re an investor?
 
The pros
• Your taxable income can be significantly reduced by claiming losses on your property.

• You can use depreciation of the property to your advantage. So this too can be added to negative gearing claims.

• Big losses on the property (such as major strata levies or hefty property maintenance) can potentially be offset once you sell the property.

• Most negatively geared properties are bought in high growth, attractive and stable areas. This the best way to achieve long term capital growth. Therefore your property should be safer from sudden market changes.

• You have far more scope to develop and existing property or subdivide a block through negative gearing. The cost of building, construction, legals and developing all come back through negative gearing. It means you can potentially add a lot of - value to your long term capital growth.

Cons

• The biggest downside to negative gearing is the high out of pocket expenses you can face. These can be very prohibitive and, if you suddenly have to install a new roof or pay for water damage, exorbitant. Simply you will need to have deep pockets to cover the loss in rentals and all the maintenance of the property. This requires skilful budgeting.

• The higher debt you’re potentially accumulating leaves you open to any sudden interest rate rises. Also, if you’re using equity to cover negative gearing this can leave you even deeper in debt and more vulnerable to sudden spikes in the market.

• Negative cash flow properties are a longer-term strategy. So you can’t rely on them as a quick cash solution.

• Vulnerable to market whims and moods. No capital growth rate is ever assured. Yes, it’s true that most negatively geared properties are in resilient, high growth suburbs. But if the entire property market’s bubble bursts or some unforseen factor drives prices down (natural disaster, industry collapse or over development) then you could be stuck with a property losing money with no capital growth.

• It’s harder to build a big property investment portfolio as you have to outlay so much cash. Unless your pockets are very deep, the sheer costs of negatively gearing will prevent you from having as many property investments as you may like. At least in the short term.

• It prevents you from being agile – you’re tied down to a property in the long term. If you’re a small-medium investor this limits your overall investment options. Say if some fabulous investment opportunity arises, you may not be able to tap into it because you’re committed to the long term capital growth of your property and may not have free cash available.

So there are very strong arguments both for and against negative gearing. At the end of the day, you’re best to talk to a professional about what choice will work for you. Many investors come asunder through hasty or poorly informed decisions. And with so much fevered interest in the current property market that’s not a mistake anyone wants to make.

SAM KHALIL is founder and director of Direct Property Network.