Debunking Negative Gearing: Why it May Not Be the Best Path to Wealth Growth
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Negative gearing has long been a buzzword in real estate investing, promising tax benefits and potential long-term gains. However, as savvy investors are learning, it might not always be the golden strategy it's often touted to be. In this blog, we will go into the nuances of negative gearing and discuss why it might not be the optimal route to grow personal wealth. To illustrate our point, we’ll be using two fictional Aussies, Jimmy & Matt, to do a side-by-side comparison of their imaginary portfolio.
Disclaimer
Note that this is not financial advice, simply the ramblings of another investor like yourself. Please consult with your professionals before making any investment decisions.
Understanding Negative Gearing
Negative gearing involves financing an investment with a loan and using the income generated to cover part of the interest payments and other expenses. In some countries, including Australia, the investor can offset the losses from the loss-making (i.e. negatively geared) investment against their taxable income. This reduces their overall taxable income and, consequently, their tax liability. The idea is that the investor can tolerate the short-term loss in exchange for potential long-term capital appreciation of the property.
Example
Let's say Jimmy invests in three $450,000 properties that each generate a rental income of $20,000 per year, but his mortgage interest, property management fees, and other expenses amount to $30,000 per year. This creates a net loss of $10,000 on each property, meaning he’s not making a profit from it.
Now, let's consider Jimmy’s total taxable income before any deductions: $100,000.
If we include the net loss from the property portfolio ($10,000 x 3) as a deduction, Jimmy’s taxable income becomes: $100,000 - $30,000 = $70,000.
This reduced taxable income of $70,000 will result in you paying less income tax. Congratulations, negative gearing has helped you reduce your overall tax liability!
But wait, there’s more! Based on a 5% capital growth rate, Jimmy’s portfolio just increased in value by $60,000. In the next 5 years, Jimmy is expecting his portfolio value to continue to grow to a total value of $1,530,000
Why is this NOT Savvy?
Dependence on Capital Appreciation
Negative gearing hinges on the assumption that property values will appreciate significantly over time. While property markets do tend to rise over the long term, this isn't a guarantee. Relying solely on capital growth to offset losses can be risky, especially in volatile markets.
Cash Flow Constraints
Negatively geared properties typically generate less rental income than their expenses, leading to ongoing out-of-pocket expenses for the investor. This can strain personal finances and limit the ability to invest in other opportunities that offer more immediate returns.
Market Fluctuations and Risks
Real estate markets can be unpredictable, influenced by economic factors, interest rate changes, and regional trends. A market downturn can exacerbate the negative cash flow situation and put investors in a precarious position, as we’ve experienced with the recent interest rate hikes.
Tax Benefits Not Guaranteed
Tax laws can change, and governments may alter the rules around negative gearing. Relying solely on tax benefits as a primary investment strategy might lead to disappointment if regulations shift.
Our Preferred Strategy
We believe that investing in assets with consistent positive cash-flow to be a more sustainable path to wealth creation. Positive cash flow properties generate surplus income from day one, allowing investors to reinvest, diversify, or meet other financial goals. These investments will also appreciate in value in the same way that the $450k negatively-geared property will, just without the immediate losses.
Example
Instead of three $450k homes, Matt decides to invest in a single $1.25m cash-flow positive property. After paying off all expenses, he’s left with a positive cash flow of $30,000, bringing his total income to $130,000.
The asset appreciates in value all the same at 5% per annum. In the next 5 years, Matt is expecting his property value to grow to a total value of $1,530,000
Compare and Contrast
Jimmy: Negative Gearing Strategy
Income: $70,000
$60k growth
Estimated tax: $13,217 (Based on 2022-23 calculations)
Net position: $116,783
Mateo: Cash-flow Positive Strategy
Income: $130,000
$60k growth
Estimated tax: $33,167 (Based on 2022-23 calculations)
Net position: $156,833
On top of the improved financial position, there’s now more assessable income that can be shown to your lender. Will this allow you to borrow more? Ask your broker 🙂
Note that we’re not even including factors like CPI, depreciation, asset protection structures, tax reduction strategies, etc. We’re simply looking at it like a balance sheet.
Question for you: do you want to be more like Jimmy, or Matt?
Closing Remarks
While negative gearing may have its place in certain investment strategies, it's crucial to evaluate its suitability for your individual financial goals and risk tolerance. Building wealth through real estate involves a comprehensive approach that considers factors beyond just tax minimisation. Embracing investments that offer positive cash flow and align with a broader financial plan can lead to a more sustainable and rewarding path to growing personal wealth.
Remember, successful wealth creation requires due diligence, careful planning, and seeking advice from financial professionals who can help tailor an investment strategy that aligns with your aspirations and risk appetite.
If you wish to learn more about cash-flow property strategies, reach out to us at admin@mateogroup.com.au
