a guide to gearing

You’ve probably heard hype surrounding the concept of gearing. Gearing is basically borrowing to invest. More often than not people borrow to invest in property, but you can also borrow to invest in shares in the form of a margin loan. The hype is all about negative gearing, but what is it and what are the other forms of gearing? Below is a quick explanation of gearing.

Positive Gearing

Positive gearing is when you make a profit on your investments (and have to pay tax on that profit). A property investment is positively geared when the rent more than covers all of the expenses associated with the property. A positively geared investment generally means that you are earning a passive income and don’t have pay expenses related to the property out of other income (like your salary).

Negative Gearing

Negative gearing basically means that the expenses of an investment are higher than the income generated and you make a loss. In the case of a property investment, the rent doesn’t cover all expenses and you need to make up the difference through other income streams such as your salary.

As far as property investment goes, negative gearing is generally the easiest and most common investment option. It enables you to purchase an investment that you would otherwise not be able to afford with the bonus that the yearly loss is tax deductible against your other income, reducing the amount of yearly tax that you pay.

There are circumstances where negative gearing is a good option and circumstances where it is not a good option. The effectiveness of negative gearing at reducing your tax will depend on the tax bracket that you’re in. Personally, I’m not a fan of making a loss on purpose purely to get a tax deduction but that’s just me, and that’s not the only reason a person may choose to negatively gear.

The idea behind negative gearing is that its a long term strategy: you hope the capital value of the property will rise at a higher rate than the annual after tax loss. The downside to negative gearing is that the amount that you can increase your investment portfolio is limited to how much you can spare from your regular income.

Neutral Gearing

Neutral gearing means that your investment income covers your investment expenses but no more. You make neither a profit or a loss on your investment. There is no tax paid nor is there a tax benefit. Finding a property with neutral gearing is harder unless you invest more capital upfront (pay a bigger deposit to reduce interest expense). The hope is that either it will become a positive geared investment in the future, or the capital value of the investment will rise and you make a profit on its sale.

The ‘Other’ Gearing

I’m not sure the name of this, many writers refer to this as positive cash flow (Margaret Lomas is one of the best on this topic). Personally, I like this gearing the best, but an investment geared this way is also the hardest to find.

Positive cash flow combines both positive and negative gearing. Basically, your income is more than your expenses meaning that you make an actual cash flow profit and have extra in your pocket every week. However, as far as tax goes, the investment makes a paper loss. An example of this is where the rent from a property investment covers all expenses, but once you factor in depreciation, it turns the profit into a loss. This loss is then a tax deduction against your other income.

For more information on the ins and outs of property investing and tax, the Australian Tax office has a detailed PDF info sheet to download.

Disclaimer: This is general information not financial advice. Seek professional financial advice when deciding what investment options are best for your circumstances.