Negative Gearing Meaning Explained Calculation Example

Negative Gearing Meaning

The phenomenon is predominantly seen in real estate and financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more. Investors use borrowed funds for picking investments like real estate properties and shares. As a result, the possibility of incurring loss is not uncommon; they may receive rental income and dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more inadequate to cover interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more. In such cases, the loss offsets the total taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more.

Key Takeaways

Negative gearing happens when loss due to income from investment falling below the investment expenses is utilized to reduce total taxable income.The investors benefit from reduced tax liability in the short term. In addition, an increase in asset market value will help extract capital gain as a long-term goal covering all initial losses.Examples are buying real estate or shares using borrowed funds to reduce taxable income.The strategy will not be beneficial, If the mortgage interest rises without a rise in investor income or if real estate value decreases, causing no potential capital gain.

How Negative Gearing Works?

Negative gearing is a beneficial technique to many taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more. They can subtract the losses they make on investments from their taxable income. So, it is distinct that it reduces their tax burden in the short runShort RunA Short Run in economics refers to a manufacturing planning period in which a business tries to meet the market demand by keeping one or more production inputs fixed while changing others.read more. The strategy’s ultimate success lies in asset appreciation. The increase in market value over time and subsequent sale of assets results in the capital gainCapital GainCapital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price.read more covering the initial losses.

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There are several other advantages to this technique. When it comes to rental income, it is taxed like ordinary incomeOrdinary IncomeOrdinary income refers to an individual’s or business entity’s earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more. If the losses are deductible against personal taxable income, the system allows passive investmentPassive InvestmentPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.read more losses to be written off against labor income. In certain nations, maintaining high home values is vital in the viewpoint of politicians to avoid diminishing the fortunes of the majority of voters, that is, property owners.

Rich and high earners can utilize this strategy because they can easily afford to borrow loans for investment purposes. Therefore, the greatest share of the benefits goes to them – and the biggest growth is to those owning multiple properties. However, it is not perceived as a safe option for low-income people. Furthermore, the strategy which differs from this is positive gearing, in which the investor can use the adequate cash inflow from investment to pay expenses.

The negative gearing process reduces the government’s taxation revenue. For example, negative gearing in Australia reduced the nation’s income tax revenue significantly. When countries like Japan and Australia allow this technique, countries like Canada, and America, permit it but are constrained by restrictions. Recently, New Zealand has decided to shut down its policies leading to negative gearing in investment propertyInvestment PropertyInvestment property refers to the real estate acquired to earn returns on the investment through rental income, royalties, dividends or future appreciation, usually in the name of an individual investor, a group of investors or an investment company for a short-term or a long-term investment.read more to control its housing market.

Calculation Example

To get negative gearing explained, let’s take the example of Janice. It is a simple example of negative gearing in property, but in complex or real cases, many external and internal factors need to be considered for calculating the taxable income. For instance, one should consider depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more and check whether the loss is limited according to guidelines.

Janice has taken a mortgage loan from a bank to purchase a residential rental property. She rents it to a family, the family pays a rent of $1300 every month, so technically the annual rental income received by Janice is $15600. However, when the cash inflow in the form of rental income is compared to the cash outflow due to expenses incurred for holding or maintaining the property that equals $20,000, Janice incurs an annual loss of $4400. In essence, the expenses exceed rental income.

Janice is also an engineer and works at a private firm. The taxable income of Janice is $36,000. However, Janice claims $4400 in the taxation process as a loss on her negative geared property, and the shortfall is subtracted from her annual income. Earlier, she was paying tax on her annual income of $36000, but after the shortfall is offset, which is $36000 – $4400 = $31600. Therefore, the new taxable income of Janice is $31600. In this way, Janice enjoys tax benefits.

Risks

It can cost a lot of money to the investor. For example, if the mortgage interest rises, without a simultaneous increase in rent, and investor income reduces, the investor will find it difficult to pay for liabilities like interest and taxes.If the interest rate drops, the cost also decreases, hence loss also reduces.A significant decline in the real estate values may bring trouble to investors. The investor fails to make a capital gain from the property sale if the housing or real estate market is down.For the property to generate cash inflow, the investor must first find a tenant ready to move into the property, agreeing on a considerable rent. Governing entities like IRS limits the types and amounts of expenses or losses taxpayer can deduct for a rental property.Due to increased unproductive asset speculations, this practice can cause assets or house price inflation.