What is gearing and how can I use it to invest in property?

Answer

The term gearing simply means borrowing money to invest—you can borrow to invest in an investment property, a business, shares or managed funds.

Borrowing to invest increases risk significantly but can potentially help build wealth faster. For example, rather than saving $450,000 to buy an investment property, most people borrow a large portion of the property price with the aim of getting into the property market more quickly and achieving capital growth as the property’s value increases.

An investment can be negatively, neutrally or positively geared—it depends on the relationship between the costs of owning the investment and the income generated. Here are the differences.

Negative gearing

What is it?

  • When the interest payments and other investment costs are higher than the income you receive from the investment.

How can it affect my tax obligations?

  • You can claim a tax deduction for the interest and investment costs, which may reduce the overall tax you pay on your other income.

Neutral gearing

What is it?

  • When the interest payments and other investment costs are equal to the income you receive from the investment.

How can it affect my tax obligations?

  • This strategy is less tax-effective but you can claim a tax deduction for the interest and investment costs against your investment income. You won’t be able to reduce the tax you pay on your other income.

Positive gearing

What is it?

  • When the interest payments and other investment costs are lower than the income you receive from the investment.

How can it affect my tax obligations?

  • It is less tax-effective than negative gearing but you can claim a tax deduction for the interest and investment costs against your investment income. However, the income generated will be subject to income tax. You won’t be able to reduce the tax you pay on your other income. However, you can use the surplus income to reduce the size of your loan.

Effectively gearing your investments

How and whether you can use gearing will depend on your circumstances. Generally an effectively geared investment:

  • needs a reliable cashflow to cover pre-tax borrowing costs
  • has an investment time frame of at least five years to make the most of the investment’s potential to build wealth (but it depends on the type of investment you choose)
  • generates a reliable, long-term income
  • provides income growth and becomes positively geared—ideally as debt decreases the investment’s yield increases (eg rent from an investment property or dividends from shares) so you’re earning more but may have to pay more tax.

If you’re thinking about investing in a rental property you need to demonstrate an ability to repay the loan, including during times when the property may be vacant or interest rates rise. Some lenders may not take potential rental income into account when determining your ability to repay the loan.

And it pays to be aware that while borrowing money to invest delivers the potential for greater returns there is also the chance of an increase in losses too. Before considering a gearing strategy, seek financial advice to ensure you understand the potential risks and benefits involved.

 

Important information

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It’s important to consider your particular circumstances and read the relevant Product Disclosure Statement or Terms and Conditions before deciding what’s right for you. This information hasn’t taken your circumstances into account.

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