Learn how to gear your investment property to your advantage.
Do you want to become financially independent from your investment properties?
In this article Real Estate Investing Australia discuss all things ‘gearing’ and how you can use this to your advantage to acquire incoming earning assets.
ALL ABOUT GEARING
If we could only buy property when we’d saved up enough to do it, it would take us a very, very long time.
The lack of demand this would create for property would certainly keep prices down, as only a few people would be able to buy and it would make property a terrible investment.
Luckily, we don’t have to wait until we can afford to buy a property outright, as banks and financial institutions provide loans and mortgages to make up the difference between what we can afford, and what the property costs. By using money from banks or other lending institutions we can buy higher-priced properties that we couldn’t otherwise afford. This is called gearing.
Gearing is a technique used to acquire more and more income-earning assets. Smart investors know that by borrowing money, they can get assets that will appreciate in value, add to their long-term wealth and make sure they stay financially independent.
The wealthy have been doing this for a long time, but just a generation ago, in our parents’ time, borrowing money and getting into debt was seen as something to be avoided at all costs.
But since the 1970s, banks and other lending agencies have made it a lot easier for ‘ordinary people’ to get credit, and borrowing has become accepted as part of modern day life. Of course the flip side is, that as people have borrowed more they’re saving less, as they’re using more of their income to make repayments on loans.
Just because you can borrow money doesn’t mean you should get into needless debt, especially if all you are doing is funding a lavish lifestyle you can’t afford. That’s unsustainable and not a smart way to use borrowed money. However; unfortunately it’s something far too many Australians do.
On the other hand, if you’re increasing your debt levels by borrowing to buy income generating assets, that’s a different matter altogether, because then your borrowing will effectively be paying for itself from the income you receive from the assets. Ideally, the return you make on investments bought with borrowed money will be more than the cost of the loan repayments, giving you a positive cash flow from the start. But even if it doesn’t, the tax advantages on negatively geared properties, where the money they bring in is less than their costs, means you can still be better off over the course of a year.
Of course borrowing money and increasing your debt is not something everyone wants to do. Some people hate the idea of taking on any debt. Instead, they prefer to pay for everything in cash, and when it comes to property, they rent.
Another group is a bit more comfortable with the idea of debt, so may allow themselves a small amount, for instance to take out a loan to buy a car. Others are completely comfortable with borrowing and will happily take on millions of dollars worth of debt because they know they’ll be getting a great return from the assets they buy with it.
So, presuming you are willing to take on debt to finance your long-term financial freedom, there are three types of gearing you need to be familiar with: positive, neutral and negative gearing.
If all the costs of owning a property, such as the interest on the loan and bank charges, maintenance and repair costs, are less than any income the property brings in, then it’s said to be positively geared. In other words, it’s a property that’s earning you money each month.
Neutrally geared properties are those where the costs are just about equal to the income the property brings in.
Obviously, a neutrally geared property is a good investment since you don’t have to worry about it costing you anything each month as you wait for it to rise in value so you can sell.
Negatively geared properties actually cost you money each month because your rental expenses are greater than any income the property brings in. On the face of it, this doesn’t seem particularly smart and common sense says if you are losing money you should get rid of the property as soon as possible. However, when you have a negatively geared property, you get some help from the taxman.
So, how does the taxman help investors with negatively geared properties? The taxation office allows investors to subtract any losses from an investment property from their overall income. This means you reduce the amount of overall tax you are expected to pay in any given year. When you consider this, a negatively geared property isn’t so bad. However, the only way you will make money long-term from a negatively geared property is for its value to appreciate so the capital gain you make when you sell is more than the losses you accumulated whilst owning the property.
Hopefully, having a negatively geared property will only be a short-term situation and things will change so that it turns into a neutrally geared property or even one that earns you money. As, whether a property is positively, neutrally or negatively geared right now is actually only a temporary state, because changes to your finance costs, for instance if are paying a variable interest rate on your loan, or putting the rent up or down, can quickly shift a property from one category to another. In which case, neutrally geared properties can suddenly turn into negatively geared ones and vice-versa.
So, before investing in a negatively geared property, you need to be confident it will soon start earning money or that you’ll receive tax advantages, something you should discuss with an accountant or tax adviser. Even then, tax rules can always change, so you must be sure of its long-term potential.
Many property investment experts recommend buying property in areas where there’s always a high demand. This means that even if properties in these areas are more expensive to buy in the first place and your initial rental income means they’re negatively geared; in the longer term this type of property will nearly always achieve higher capital growth, making you better off than with rental income alone. That’s why many investors are happy to wait for rents to increase, at which point their negatively geared property investments start turning a positive cash flow.
Whether that’s right for you as a property investor, is just one of the decisions you’ll have to make to get the balance right between short-term rental income and long-term capital gain.
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