What it is:
How it works/Example:
For example, let's assume John borrows $1,000,000 to buy a bed and breakfast. He must make interest payments of $5,000 a month on the loan, and he must spend at least $1,000 a month on maintaining the property so as to attract customers. If the bed and breakfast only generates $4,000 a month, John's shortfall is $2,000 per month.
If he's allowed to implement a negative gearing strategy, John can deduct the $2,000 monthly loss, which saves him $600 in monthly taxes assuming he is in a 30% tax bracket. If he sells the property five years later for $1,500,000, John's cash flows look like this:
$4,000 per month from operations
$600 per month in tax savings
Total Inflows: $4,600 per month
$5,000 per month in interest
$1,000 per month in maintenance
Total Outflows: $6,000 per month
Net Outflows = $1,400 per month x 60 months = $84,000
Add Capital Gains on Sale: $500,000
Net Inflow: $416,000
Why it matters:
As the example shows, negative gearing allows taxpayers to deduct investment losses. The trick to making the strategy profitable is achieving a capital gain on the eventual sale of the asset. For this reason, in countries that allow negative gearing, some investors will actually look for money-losing ventures simply to get the tax deductions. In those circumstances, the investors are betting that they can eventually sell the asset for a capital gain or at least break-even, thereby allowing them to enjoy tax deductions along the way.
Of course, these investors should be sure they have the cash to support a money-losing operation in the interim. Note too, that the expected capital gains should exceed the total losses the investor incurs during the holding period.