If you’ve been thinking about buying an investment property or already own one, then it’s likely that you’ve come across the word ‘gearing’ and wondered what it refers to. So rather than leaving you in the dark, we’ve decided it’s time to shed some light on gearing so you understand how it affects you.
Gearing is the process of borrowing money in order to buy an investment, which in this case is property. When buying a property the process requires a regular income that is able to sustain the costs of home ownership.
However, the buying of an investment property differs from the purchasing of a home, as investors search for a tenant to help offset the costs of purchasing the property. In this respect, property gearing is designed to make a profit.
When it comes to purchasing an investment property, there are two types of gearing that can used, positive and negative gearing. Let’s look at both of these in greater detail.
When an investment property generates more income than it costs to maintain, then it is positively geared. Therefore, it can be said the property generates a profit, rather than a loss. For example, let’s say an investment property is purchased for $400,000. The buyer of the property takes out a 25 year home loan at 5 percent. The monthly repayments for this property are $1,667 per month and its outgoing costs are $600 per quarter or $150 per week. Therefore, the total cost to maintain the property per month is $1817. The owner of the property collects $500 per week for the investment or $2,000 every 4 weeks. This means that the property is giving the owner of the property a return of $183 every month.
In order for a property to be positively geared the rent collected for the property must be greater than the cost of the home loan repayments, maintenance costs and the interest the home loan incurs. This means that the owner of the property then gains an additional income stream.
Positively geared property can be purchased to make a short-term profit through rent. This usually occurs when interest rates are low, and rental rates are high. Positive gearing is usually practiced in areas that are experiencing employment growth, which increases the demand for rental property. This, in turn, allows the property owner to charge higher rents and to make greater profit.
All income on a positively geared property is taxed. Therefore, it’s important that the property is well maintained and that it is sold while its value is high, otherwise over time the property may incur a loss.
There are a number of advantages and disadvantages associated with positive gearing, these are as follows:
• Stable income – Rental profit is immediate with the property investor gaining an additional income stream.
• The property is self-sustaining – The property pays for itself allowing the investor to pay for the maintenance of the property without added expense.
• Builds borrowing power – The extra income and asset value of the property make the investor more attractive to lenders, which means investors can use this buying power to build on their property portfolio.
• Profits can turn into loss – In order to make a good return on the property the investor will need to work to keep the property maintained, and to ensure a high rental yield and low vacancy rate. If demand for the property falls due to economic changes in the region the home is situated in, then the owner could make a loss on the property when it comes time to sell.
• Long-term gains are less – Depending on where the property is located to immediate gains from rental income may not be able to be sustained long-term.
• Tax payment – The additional income made from the property will be taxed. If you have a number of properties that are positively geared then this may see you move into a higher tax bracket.
Negative gearing occurs when a property is rented for less than its costs. A negatively geared property is used to make long-term capital gains as the property is typically bought with the expectation that it will grow in value over time. Therefore, the profit made when the property is sold will outweigh any short-term financial loss.
Negative gearing is a taxable loss, which allows property investors to offset against their income to reduce the tax that they pay. As such, there are advantages and disadvantages to using this form of gearing when purchasing an investment property, these being:
• Higher long-term profit – The profit earned from selling the property exceeds long-term costs.
• Reduced tax – Property owners can reduce their taxable income.
• Properties can be developed – Over time the property can be improved to increase its value.
• Ideal when interest is low – Negative gearing is suited to low interest rates as it costs less for investors to maintain a property, which means that they make a higher return later.
• Careful research is needed – Before buying a negative geared investment property, the investor needs to find an area and property that will increase in value overtime so that they get a good return on their investment at a later date.
• Optimal timing when selling – In order to make a profit, the investor needs to sell when property prices are high.
• Greater expense – A higher level of income is needed to maintain the cost of a negatively geared property as the property will incur more cost long-term.
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