A dollar sign on a scale with a house

For property investors in Australia, a clear grasp on the concept of gearing is essential when it comes to being able to make sound investment decisions.

Simply put, gearing means borrowing a sum of money to purchase an asset – in this case, a property.

Gearing can take three forms: negative gearing indicates that the value of the interest you are paying on the loan and other expenses is higher than the property generates in income (i.e. rent and the like), neutral gearing means that the income is equal to the overall expenses, and positive gearing happens when the income is greater than the sum of the interest you are paying and other expenses.

When is losing money a good thing?

Usually, based on the information above, you'd probably want to aim for positive gearing. After all, who wants their investments to cost more than they're making? Property investors in Australia, however, have always seen the positives in putting their assets in negative gearing.

One of the key advantages associated with having a property negatively geared is the potential for capital growth. While negative gearing allows for a short-term gain, property investors may be able to take advantage of a long-term financial boost when the value of the negatively-geared property jumps. For example, if you purchase a property that is negatively geared but are able to sell it for both more than you've paid initially as well as the additional costs, you'll be coming out on top.

Another advantage of negative gearing is the ability to offset that loss against the other income you earn, the most common income source being salary. In this case, your taxable income is actually reduced because of your negatively-geared property, so the expenses related to the property are now being shouldered by rent, tax deductions, or possibly by other forms of surplus cash flow or savings.

You can use this negative gearing calculator to get a sense of how your net income from your investment will look given certain circumstances.

What are the tax deductions you can take advantage of?

As mentioned, a negative geared property can (and arguably should) lead to tax deductions for the owner/property investor, of which there are three main types. The first type consists of revenue deductions, which include interests, maintenance expenses and recurring costs in the form of bank and agent fees, advertising fees, cleaning costs, insurance – all deducted from the current year's income of a property investor.

The second type of deductible expense are claims for capital items that are subject to depreciation. For this type of deduction, the property investor must claim this cost over a longer period of time, rather than doing it all at once.

Lastly, investors may be able to claim depreciation of capital works for building and landscaping, with a rate of 2.5% over 40 years.

The Australian Taxation Office has helpfully laid out an additional list of expenses that you can and cannot claim. Some of things you can't? Bills like water and electricity charges, as these are not paid by you but by your tenant.

Acquisition and disposal costs, include the purchase cost, conveyancing and advertising costs and stamp duty on the title transfer, are also not things you can claim, as these expenses are included in the property's cost base which would trim any capital gains tax when you decide to dispose of the property.

What are the potential risks of negative gearing?

Negative gearing is not without risks and repercussions. For property investors who do not have a substantial amount of money in their war chest, putting a property into negative gearing would not be the best option. Remember, you still record a loss with this strategy, so it is best to think ahead about the worst case scenarios.

Another potential risk arises when you become completely dependent on capital gains to the point that you may not be able to make any money should the market see sudden price falls.

Relatedly, there is also the danger of a sudden interest rate changes, which may make it difficult for you when it comes to raising the rent.

How can these risks be avoided?

There are many things you can do to minimise the risks associated with negative gearing. Like many investment decisions, you have to make sure that you choose your property wisely. See to it that the property you will be investing in is in a major location, which will ensure high demand for occupancy.

It is also a must for you to have a significant amount of buffer finance. This will cover unforeseen expenses should your property becomes vacant or in the event it needs repairs. You should take your sources of income into account and your ability to manage all the costs owning a property entails.

Putting your property under insurance is also vital to protect yourself from the worst case scenarios.

What about positive and neutral gearing?

As previously mentioned, a property is positively geared when the income from renting the property outweighs the cost of owning and managing it. The gains are then taxed, and whatever remains is the net profit from your investment. While Neutral gearing is a seldomly occurring event, many investors would consider the property to be neutral if either the profit or loss was insignificant.

To find out what type of gearing is best for you, read this: Which type for gearing is best for you