Chapter 7 - It's not about the tax 

When should negative gearing be used to reduce a tax bill?

When should negative gearing be used to reduce a tax bill?

The answer is never. Clients should only borrow money to buy an asset if the expected income plus the increase in the asset’s value exceeds the interest and other costs connected to owning the asset. In other words, the expected total return must exceed the expected total cost of the investment.

This means that the expected before-tax gross income plus the expected before-tax capital gain must be greater than the prevailing interest rate before a rational investor would borrow to buy an income-producing investment. If the level of income plus capital growth is below this you will lose money.

How high you go above the prevailing interest rate depends on your perception of the risk implicit in the investment. As a guide, we often suggest that the rate of income plus capital return should be about 4% higher than the prevailing interest rate.

Without such a margin it’s just not worth the effort. If this base condition is not met, it doesn’t matter that the net loss on owning or holding the investment is tax-deductible. A loss is a loss. You would actually be better off paying income tax and putting what’s left of your money in the bank.

It’s critical to see negative gearing as an investment strategy with a tax benefit, rather than a tax strategy with an investment flavour. Clients should never negatively gear an investment just to get a tax benefit. Negative gearing only makes sense where the client genuinely and reasonably expects the after tax capital gain on ultimate sale, plus a premium for risk, to be significantly greater than accumulated tax losses on holding the asset, adjusted for the time value of money.

6. Don't mix your debts
8. Positive gearing