Negative GearingWhen the returns from an investment isn't enough to cover its costs

Patrick Louie

Normally, when you invest in an asset, you want to earn profits from investing in it.

For example, you borrow funds to purchase a building.

You then convert the building into an apartment complex that has residential and commercial spaces.

With the expenses of converting the building, as well as the interest expense from borrowing, you would want your investment to earn at least enough revenue to cover them all, right?

That way, you wouldn’t have to shell out extra cash just to be able to pay for expenses and debts.

Well, that’s normally the case. You would want your investments to make profits.

And the first step for that to happen is to have the investments earn enough revenue to cover the expenses related to them.

However, would you believe me if some investors actively seek the opposite?

Well, you should because such a practice exists!

And we refer to it as negative gearing.

Instead of wanting the investment to earn enough revenue to cover all related expenses, an investor that’s employing negative gearing would rather want the investment to not do so.

Essentially, the investor wants the investment to produce a loss (at least, in the short term).

But why would any investor want that?

In this article, we will be exploring what negative gearing is.

Why do some investors employ negative gearing?

Is it a technique that is applicable to all kinds of assets/investments?

What are its pros and cons?

What are the elements of successful negative gearing?

We’ll try to answer these questions as we go along with the article.

What is Negative Gearing?

negative gearing

Negative gearing occurs when an investor uses borrowed funds to purchase an income-earning asset/investment that doesn’t produce enough cash flow to cover interest and other related expenses (e.g. maintenance, depreciation, etc.).

Ideally, this insufficiency in the cash flow should only occur in the short term.

For example, an investor borrows funds to purchase a rental property.

The investor incurs the necessary expenses to make the rental property habitable.

However, the rental income that the property produces isn’t enough to cover all of its costs (interest, principal payments, maintenance, property taxes, etc.).

As such, the investor is essentially generating a loss from the investment.

At a glance, negative gearing seems to be harmful and destructive.

I mean, why would anyone want to generate losses from his/her investment?

Well, there’s a reason for that.

You see, depending on the country, the loss from negative gearing may lessen an investor’s tax liability.

Countries that fully allow this deduction in tax are the following:

  • Australia
  • Japan

Meanwhile, the following countries allow losses from negative gearing to be a tax deduction but with restrictions:

  • New Zealand
  • United Kingdom
  • Canada
  • United States
  • Germany
  • Netherlands
  • Sweden

However, it’s not all losses from negative gearing.

Hopefully, the asset/investment will eventually produce enough cash flow to make up for the losses as well as its cost.

In a sense, one can say that negative gearing is successful if the loss is only temporary. The common way to recover from losses and costs is through the sale of the asset.

However, this situation is only attainable if the value of the asset/investment is on the rise during the time of sale.

If the value of the asset/investment is falling or holding steady, the investor might not be able to make enough money from the sale of the asset to produce an income.

Elements of Successful Negative Gearing

Being able to reduce taxable income with negative gearing is already a win.

However, that isn’t enough to make negative gearing a profitable action.

The loss should only be temporary.

Given time, the asset/investment should ideally produce enough cash flow to offset the losses and costs.

This is primarily attainable through capital appreciation, where the value of the asset/investment rises over time.

As such, the common negatively geared assets are real properties such as land, rental property, etc.

As of this article’s writing, the value of the US housing market has doubled since the great depression.

Since the investor will be taking losses in the short-term with negative gearing, s/he will need to have enough financial stability to fund the shortfall until such time that s/he can sell the asset/investment and earn a profit.

Not having the funds to answer the costs of the asset/investment can be harmful to the investor as it may lead to more losses, and eventually, foreclosure of the property.

As for the tax advantage of negative gearing, it’s really only beneficial if the investor/buyer is already earning a high income, thus, more incentive to reduce tax liability.

For someone who is paying little to no tax, the loss from negative gearing won’t do much good.

Rather, it might be more harmful as losses can contribute to bankruptcy.

Lastly, not all countries allow the losses from negative gearing to be tax deductible.

So before an investor employs negative gearing, s/he must check the tax laws of his/her country first.

In summary, for negative gearing successful, it must have the following elements:

  • The value of the asset/investment increases over time (capital appreciation)
  • The investor should have enough financial stability to shoulder the losses; and
  • To fully take advantage of the deduction in the tax liability, the investor should be earning a high income

The Risks of Negative Gearing

negative gearing

While negative gearing has its advantages, it also comes with risks:

The risk of not having enough cash flow for repayment

Negative gearing typically involves borrowing money to purchase an asset/investment.

While only the interest and other related expenses count towards the calculation of losses, one must remember that the investor still has to make principal payments on the loan.

The inability to make interest and principal payments may lead to unnecessary expenses such as penalties and late fees.

In the worst case, the creditor might foreclose the asset/investment.

This is why financial stability is important for negative gearing to work.

The risk of the asset/investment not earning any income at all

In the case of rental property, there is a risk that the investor may not find any tenants at all.

This results in the property not earning any income at all, which might increase the loss from negative gearing.

However, this also exemplifies the risk of not having enough cash flow to answer all costs related to the asset/investment.

The risk of significant property depreciation/impairment

To make negative gearing profitable, the asset/investment must appreciate in value.

This is why the most negatively geared assets are real properties.

However, even real properties may experience significant depreciation or impairment.

For example, an earthquake may destroy a significant portion of a rental property.

Such an event makes earning a profit from the sale of the asset a much more challenging task to accomplish.

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  1. Penn State "When and Why Do Landlords Retain Property Investments?" Publication. August 25, 2022

  2. Internal Revenue Service "Topic No. 414 Rental Income and Expenses" Page 1 . August 25, 2022