Borrowing to invest is called ‘gearing’. If you borrow to invest and you make a profit, you are positively geared. If you make a loss, you are negatively geared. Either way, gearing is costing you money.
Borrowing to invest can impact your finances and have tax implications so make sure you do your research so you are comfortable with your decision.
Negative gearing is where you borrow money to invest and the income from the investment is less than the expenses. For example, if you borrow to buy a property and rental income is less than interest and other expenses, you’re essentially making a loss.
If you borrow money to invest in shares your investment will be negatively geared if the dividends from the shares are less than the interest on the loan.
Negative gearing is a popular strategy to minimise tax, but remember, you can only reduce your tax if you reduce your taxable income. Don’t focus on the tax benefits of negative gearing without considering the reduction in your after tax income.
You may be prepared to accept ongoing losses if you expect to have a capital gain in the future when the value of the investment increases. There is no guarantee this will happen and in the meantime you’ll have to cover the shortfall from other income. If interest rates rise, you’ll be out of pocket even more.
Positive gearing is where you borrow money to invest and the income from your investment is higher than your interest and other expenses. This means you’ll have extra money in your pocket, but you will have to pay tax on the additional net income.
Positively geared investments increase your income and may also generate a capital gain in the future if your investment increases in value.
The impact of gearing on your cash flow
The following example shows the difference between buying an investment property that is negatively geared and buying a property that is positively geared.
Let’s assume CPL King earns $70,000 per year and is buying an investment property worth $400,000. He takes out an interest-only investment loan at 4% pa, additional property expenses are estimated at $5,000 a year, and rental income is expected to be $300 a week.
In the first scenario CPL King has only saved enough for a 5% deposit plus buying costs, including Lenders’ Mortgage Insurance (LMI), so he will need to borrow $380,000 to buy the property. In the second scenario, CPL King has inherited $300,000 and is able to cover buying costs from his savings, which means he only needs to borrow $100,000.
CPL King’s income before buying an investment property
Medicare levy has not been included as full-time ADF members do not pay the Medicare levy
Calculations do not include any income tax offsets or rebates CPL King may be entitled to.
Inflation, increases in rental income or changes to interest rates may affect these calculations over time.
Capital growth is not taken into account as it does not affect current income calculations.
In scenario 1, CPL King has less money in his pocket, despite paying less tax, as most of his rental income is being paid to the bank in interest, so he has to cover some of his investment expenses from employment income.
In scenario 2, CPL King has more income, even though he’s paying more tax, as the investment is making a profit.
So while negative gearing is a popular tax minimisation strategy, you are paying less tax because you’ve reduced your income. Before you borrowing to invest, consider how this will help you reach your goals and how it fits into your overall investment strategy. See our investing money guide for help on developing an investing plan.
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