What is Negative Gearing?
Negative gearing is an investment strategy whereby an investor can deduct any shortfall in income from an investment that does not cover the interest expense and maintenance costs associated with owning a particular asset. Not every country allows taxpayers to use negative gearing strategies.
How Does Negative Gearing Work?
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:
Inflows:
$4,000 per month from operations
$600 per month in tax savings
Total Inflows: $4,600 per month
Outflows:
$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 Does Negative Gearing Matter?
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.