Which is better – positive or negative gearing? It’s one of the most common questions asked by property investors.
The answer is that they both have their pros and cons, depending on your particular circumstances.
First, let’s be clear about what these terms mean.
An investment property is positively geared when the rent income is greater than the expenses to buy and maintain it.
They include loan repayments, council rates, fixed utility charges, building insurance, strata management fees, maintenance and repairs.
Although the rent surplus increases your taxable income, it can be used to improve your serviceability for new property investment loans or to pay off your home loan.
It's sometimes possible to find properties with solid rent returns and capital growth, but generally properties with high rent returns have low capital growth and vice-versa.
This is when the rent income is less than the cost of holding the property. You intentionally make a loss that can be offset against your other income.
It’s quite legal, and is widely used by high-income earners to minimise their tax obligations.
Normally negative gearing is used to buy properties that are expected to experience substantial capital growth. When they’re sold, the capital increase far exceeds the accrued negative gearing losses.
These properties are usually found in the best locations, such as ‘dress circle’ suburbs close to the CBDs of major cities. Normally they’re a long-term investment – at least 10 years – to achieve the capital growth required to make the exercise profitable.
Of course, negative gearing can only be used while there’s enough surplus cash to fund the property’s rent income shortfall.
Which gearing you choose for your next investment property depends on your financial situation and goals.
For most investors, the best gearing strategy is a combination of the two: positive gearing for cashflow, and negative gearing for capital growth.
Positive gearing helps to build your property portfolio and enables you to enjoy the fruits of your investments, but negative gearing is the way to accumulate wealth.
When you’re young and earning a solid income, a positively geared property provides cash to leverage your other properties to buy more. As your portfolio grows you can move the balance towards negative gearing, and hold onto these properties for long-term capital growth.
When you’re near retirement, you can move towards positive gearing again to provide more cashflow for a comfortable and enjoyable lifestyle.