Chapter 1 - What is negative gearing?
Negative gearing occurs where the income from a geared asset is less than the interest and other holding costs, creating a loss in the short term while they hold the asset. Clients can often offset this loss against other income for tax purposes. This creates a tax benefit, in the form of less tax being paid than otherwise. In a sense, this tax benefit adds to the investment return on the asset.
Negative gearing does not make economic sense, however, unless the client also expects to earn an eventual capital gain greater than the short-term loss, so that overall the client is better off by making the investment. This capital gain is not taxed unless the asset is sold, and even then usually only half the gain is taxed, provided the asset was owned for more than 12 months.
A simple example shows how negative gearing works. Let’s assume a client buys $100,000 of property (obviously this is only for illustrative purposes!) using alternatively no gearing, 40% gearing and 80% gearing. After one year the property increases in value by $10,000. The position is as follows:
Gearing leverages the investment to increase gains when asset values rise.
But there is a ‘reverse’ gear too. Gearing leverages the investment to increase losses when asset values fall. Let’s assume our client stays in the market with her $110,000 of geared property using alternatively no gearing, 40% gearing and 80% gearing. In the second year the property falls in value by $20,000. The position is as follows:
Gearing makes everything bigger and faster: the gains and the losses.