Guide to Negative Gearing

On the second Tuesday of May each year, the Commonwealth Treasurer stands up in Parliament to deliver the Federal Budget. It’s an event of enormous importance to the nation, with the media and public alike paying close attention before and after the big night.

Your household budget might not have the same national importance, but from your perspective, it's far more critical to your financial wellbeing than anything the Treasurer announces.

At its heart, a personal budget focuses on two things: your income and your expenditure. The goal is simple: ensure your income exceeds your outgoings to get ahead financially. Yet, many of us struggle to know exactly where our money comes from and where it goes. Budgeting is the process of tracking this flow of money to understand your financial habits and plan for the future.

The benefits of budgeting are immense. It empowers you to make smarter financial decisions by showing you what you can truly afford. Sometimes, it delivers tough news: you might need to cut back. But often, it brings pleasant surprises. Many people discover they have more room to breathe, ramp up their investments, or boost their superannuation contributions—once they've crunched the numbers.

Viewed from another angle, a budget can show you how much you need to earn to support the lifestyle you desire. For some, this has been the catalyst to seek a higher income after calculating their present and future cost of living.

Either way, budgeting provides vital information for managing your finances. Knowledge is power, and budgets provide powerful knowledge. 💡

The best part? In today's digital age, budgeting is easier than ever. Forget dusty ledgers; if you can use a smartphone or a computer, you have all the tools you need. From simple spreadsheets to sophisticated apps that link directly to your bank accounts, technology has made tracking your finances incredibly straightforward.

This e-book is designed to guide you, step-by-step, in creating your own income and expenditure budget, putting you firmly in control of your financial future.

We hope you find it valuable, and please feel free to share it with anyone who might benefit.

Let's walk through a practical example. Andy is a self-employed plumber earning $100,000 a year after business expenses. Based on the current tax brackets, his marginal tax rate is 30% (plus the Medicare levy). Andy already owns his home, valued at $600,000, and has a mortgage of $200,000, giving him $400,000 of equity.

Here is a quick snapshot of his assets before the new investment:

Andy decides to buy an investment property for $600,000. He uses the equity in his home as security, allowing him to borrow the entire $600,000 purchase price, plus an extra $30,000 to cover stamp duty and other acquisition costs. After he makes the purchase, his financial position looks like this:

Andy’s equity has fallen, but only by the amount of the purchasing costs he had to pay.

So, the new loan constitutes the ‘gearing’ part of the term ‘negative gearing.’ Now we come to the negative part.

Andy appoints a property manager to look after the rental. The ongoing costs of the property, such as council rates, insurance, and management fees, come to $3,000 a year. The property generates a rental income of 3% on its value, which is $18,000 per year. The interest rate on his new investment loan is 6.0%. On a loan of $630,000, this equates to $37,800 in interest each year.

This is how the property's cash flow looks for the year:

These figures show that Andy makes a cash loss of $22,800 on the property each year. For tax purposes, Andy can deduct this loss from his other income. So, Andy’s taxable income falls from $100,000 to $77,200 for the year.

The income tax (including Medicare levy) payable on $100,000 is approximately $21,592. The tax payable on $77,200 is approximately $14,752.

This means that negative gearing has reduced Andy’s tax bill by $6,840. The annual loss of $22,800 is therefore partially offset by this tax saving, reducing the after-tax loss to $15,960.

As long as the value of the property increases by more than this $15,960 shortfall per year, Andy will be better off because of the investment. A gain of $15,960 is 2.66% of the property's $600,000 value. So, as long as the property market grows by more than 2.66% annually, the short-term loss Andy covers will be offset by the longer-term capital gain.

According to the 2024 Russell Investments/ASX Long-Term Investing Report, the long-term average return for residential Australian property to December 2023 was 9.3% per annum over 10 years. This total return includes both rental income (typically 2-3%) and capital growth. Over 20 years, the figure was 10.2% per annum. If historical performance is any guide, Andy's investment should be profitable.

Capital Gains Tax

If Andy were to sell the investment property, he would have to pay Capital Gains Tax (CGT). If he holds the property for more than 12 months, his capital gain is reduced by 50% for tax purposes. The remaining 50% of the gain is then taxed at his marginal rate of 30%. This means the effective tax rate on the total capital gain is 15%.

Taking this tax into account, the property's value needs to rise by slightly more to ensure a profit. If we factor in the 15% tax on the gain, the annual capital growth required to break even rises from 2.66% to approximately 3.13%.

That said, our advice with property is often to hold it for the very long term. If you never sell an asset, you never trigger a capital gains tax event.

Repayment

With this new investment, Andy should direct all his spare cash towards repaying his original home loan. The interest on that loan is not tax-deductible, making it more expensive debt. He should aim to repay that non-deductible debt as soon as possible. We discuss this further below in the section on debt management.

Negative gearing is not just for housing

The term ‘negative gearing’ often brings property to mind, but it simply refers to any situation where the holding costs of a debt-financed investment are more than the income it produces. This can absolutely apply to a portfolio of shares if the dividends received are less than the interest paid on the loan used to buy them.

As long as the income you receive from an investment is taxable (like dividends from shares), the interest you incur on money borrowed to purchase that investment is generally tax-deductible. This means negative gearing can provide a tax benefit whether the asset is property or shares.

A third main 'class' of investment is fixed interest or cash, such as a term deposit. It would be unwise to borrow money for this type of investment, as the interest you earn will almost certainly be less than the interest you pay on the loan. With no prospect of capital growth to make up for this shortfall, there is no financial benefit. So, negative gearing really only applies to growth assets like property and shares.

Property and Shares: A Tale of Two Asset Classes
We don't usually like sporting analogies for investing. After all, building wealth isn't a competition where one person wins and another loses; it's more like personal fitness, where the goal is simply to improve your own position.

But we can’t resist highlighting the 'neck and neck' race between Australian shares and residential property over the long term. Each year, the Russell Investments/ASX Long-Term Investing Report gives us a chance to see how they've performed. It's a fantastic resource because it cuts through the short-term noise and focuses on 10 and 20-year returns.

Looking at the 10 years to December 2023, the race was incredibly close:

Over 20 years, property had a slight edge:

Now, please don’t read this as a reason to sell your shares and buy property! The 'winner' changes all the time. To prove the point, let's look at the return for just the single year of 2023 from that same report. It tells a very different story:

The real lesson here is that both shares and property have historically delivered strong returns over the long term. The bumps of individual years tend to smooth out over time. It matters less which of these you choose, and more that you choose to invest for the long run. It's like deciding between going for a run or a ride on your bike. Both will improve your fitness; the most important thing is that you get moving.

There’s also a logical reason why these two asset classes perform so similarly. When house prices rise, people feel wealthier and spend more. This boosts the economy, lifting business profits and, in turn, share prices. This increase in wealth is then often used to buy more property, and the cycle continues. Australia's consistent population growth through migration also provides a strong foundation for housing demand, supporting this entire process.

The Case for Shares

The Russell Investments/ASX report is invaluable for demonstrating the virtue of patience. For example, the 2022 calendar year was challenging for share investors. The ASX 200 index fell, and even after including dividends, the total return was negative. An investor looking only at that one-year period might have felt quite discouraged.

However, one year is far too short a time to judge an investment. When we zoom out, a much more reassuring story emerges. As we saw in the table above, the average return on Australian shares over the 10 years to December 2023 was 9.1% per annum. This period included the uncertainty of the pandemic and inflationary pressures, yet long-term investors still saw their purchasing power grow significantly.

When we extend the analysis to the 20 years to December 2023, the news is even better. The long-term rate of return was 9.7% per annum. This demonstrates that investors who stay the course for the truly long term have historically been well-rewarded.

An investment returning 9.7% per year for 20 years compounds to a total return of over 540%. If you had invested $100,000 in 2003, it would have been worth over $640,000 by the end of 2023. This is why we always stress that investing is a long-term game. Ten years is a minimum timeframe; the longer, the better.

Dividend Yield

The dividend yield is a simple way to measure the income return from shares. It's calculated by dividing the annual dividend per share by the price per share. So, if a share costs $20 and pays an annual dividend of $0.80, the dividend yield is 4% ($0.80 / $20).

The long-term average dividend yield on Australian shares has historically been around 4% to 4.5%. This is a relatively high yield compared to many other global markets, and it provides a substantial part of the total return from shares. Furthermore, Australian investors often benefit from franking credits, which can increase the effective return from dividends even further. This strong income component is one of the key attractions of the Australian share market.

Agnetha owns a hairdressing salon which earns her about $100,000 a year after expenses. Her marginal tax rate is 30%. Like Andy in our previous example, Agnetha owns her home, valued at $600,000, with a mortgage of $200,000. Her starting financial position is:

Agnetha decides she wants to build a share portfolio for long-term growth. After a discussion with us, she decides to establish a line of credit loan against her home for $200,000. She plans to use this to build a diversified portfolio by purchasing units in an Australian shares index-tracking Exchange Traded Fund (ETF). At the end of the investment period, her net assets look like this:

Her chosen ETF pays an annual distribution (dividend) of 4%, which equates to $8,000 per year on her $200,000 holding. The interest rate on her investment loan, secured against her home, is 6.0%. This equates to an annual interest cost of $12,000. Agnetha therefore makes a cash loss of $4,000 for the year ($8,000 income - $12,000 interest).

This $4,000 loss is tax-deductible. At her 30% marginal tax rate, this reduces her income tax by $1,200 ($4,000 x 30%). This tax benefit reduces her effective loss for the year to just $2,800.

This means that if her ETF units grow in value by more than $2,800 (or 1.4% of the $200,000 invested), the capital gain will more than offset the short-term holding loss.

As with Andy's property example, any capital gain would be taxable upon sale, but at a discounted rate. For Agnetha to make a profit after paying Capital Gains Tax, the portfolio's capital growth needs to be approximately 1.65% per year.

As we saw in the last chapter, the long-term return on the Australian share market has historically been well in excess of this figure. With an index-tracking ETF set to largely follow the market's 20-year average return of 9.7% per annum, Agnetha's strategy puts her in a strong position to build wealth over time.

It's also worth noting that many Australian share ETFs provide franking credits with their distributions. These credits can further reduce an investor's tax liability and, in some cases, can turn a small pre-tax loss into an after-tax gain, making the investment even more attractive.

We have seen many people build substantial wealth, and it's rare to see it done without using debt. We have also seen debt contribute to financial hardship. This makes it clear that debt is a two-edged sword: used wisely, it can accelerate wealth creation; used carelessly, it can be destructive. The difference lies in the approach of the prudent investor.

In today's world, with the high cost of living and high tax rates, accumulating significant wealth from salary alone is a slow process. Superannuation helps, but for most people, its benefits are a long way off. For those who want to build wealth sooner, borrowing to acquire appreciating and income-producing assets is a well-established solution.

Tax-Deductible Debt: The Investor’s Friend
For the prudent investor, debt can be a powerful friend. Historically, those who have borrowed sensibly to acquire quality investment assets have ended up much better off. This is because, over the long term, the returns from major asset classes like property and shares have typically been greater than the cost of borrowing to acquire them. In the current environment of higher interest rates, this principle remains the same, but it places an even greater emphasis on careful investment selection and managing your cash flow.

The benefits of a geared investment strategy are enhanced by several factors:

1. Most geared investments have some of the owner’s own money (equity) in them. This means the return is earned on a larger capital base than the investor could have afforded on their own.
2. Growth assets produce capital gains, which are not taxed until the asset is sold. As the famous investor Warren Buffett has noted, this tax deferral is like receiving an interest-free loan from the government. When the asset is eventually sold after being held for more than a year, the gain is usually eligible for a 50% tax discount.
3. Tax benefits exist if the investment is negatively geared, as the annual loss can be deducted against other income, reducing your tax bill and improving your net cash flow.
4. For property investments, tax deductions can sometimes be enhanced through depreciation claims on the building and its fittings.

One of the most effective ways to manage the risk of gearing is diversification. Simply put, don't put all your eggs in one basket. By investing in a number of different assets, and even different asset classes, you can reduce the risk of a single poor-performing investment wiping out your equity.

Key Considerations Before You Borrow
It’s clear that those who have borrowed sensibly to invest over the last few decades have generally done very well. Looking to the future, it is likely that prudent investors who use debt to acquire quality assets will accumulate more wealth than those who do not.

However, this strategy is not without risk, and it is not suitable for everyone. A prudent investor should only proceed with a negatively geared investment if they can confidently say 'yes' to the following:

• Can you afford the shortfall? You must have a secure and stable income from other sources that is sufficient to cover not only your living expenses but also the cash shortfall from the investment each year.
• Can you weather a storm? You need to be able to withstand a market downturn without being forced to sell at the worst possible time. This means having a financial buffer to avoid a margin call on a share loan or to manage a period of vacancy in a rental property.
• Are you in it for the long haul? Gearing works best as a long-term strategy. The investment should be made with the intention of holding it for at least seven to ten years, preferably longer.
• Is your financial life secure? Your strategy should be flexible enough to cover major life events like serious illness, disability, or redundancy. This is typically managed with personal insurance.
• Can you actually use the tax benefits? Negative gearing works best for investors on middle-to-high marginal tax rates who can take full advantage of the tax deductions. It is of far less value to those on low tax rates or with no taxable income.

Handy Hints for Getting the Money
If you are a prudent investor with a good credit history and you're buying a quality asset, obtaining finance should be straightforward. That said, here are some tips to make the process smoother:

• Shop around. The first offer you receive is unlikely to be the best. Speak to different lenders and consider using a finance broker who specialises in investment loans. Their service can be excellent and their rates just as competitive as going directly to a bank.
• Be organised. Make sure your loan application is clear, concise, and supported by all the necessary documents, such as recent pay slips, tax returns, and statements. A well-prepared application makes a good impression.
• Don't overextend yourself. Be realistic about how much you can afford to borrow and repay. Banks will do their own assessment, but you are the ultimate judge of your comfort level with debt.
• Be upfront and honest. Always provide complete and accurate information. If something goes wrong later and the bank discovers you withheld important details, it can seriously damage your relationship with them.
• Communicate. If your circumstances change or you run into trouble, tell the bank straight away. Lenders are far more reasonable and helpful when you are proactive and honest with them. Trust is a valuable commodity in banking.

Ultimately, a bank will be reasonable with you if you are reasonable with them. It is always best to play with a straight bat.

Often, an investor who is using gearing will also have private debt, such as the mortgage on the home they live in.

It is vital that these different types of debt are kept separate. Using separate loan accounts, perhaps even with separate lenders, is the best practice. The reason is simple: the tax-deductible nature of interest on an investment loan makes it significantly ‘cheaper’ than interest on private debt.

For example, an investor paying a 6.0% interest rate on both their home loan (non-deductible interest) and an investment property loan (deductible interest) is actually paying much less on the investment loan after tax. If the investor’s marginal tax rate is 30%, the tax deduction effectively reduces the cost of the investment interest by 30%. This brings the after-tax or ‘effective’ interest rate on the investment loan down to just 4.2% (6.0% x (1 - 0.30)).

Where these two types of debt co-exist, it makes sense for all spare cash flow to be dedicated to repaying the more expensive, non-deductible loan first.

This leads to a common and powerful strategy often called ‘debt recycling’. The goal is to pay down your non-deductible home loan as quickly as possible, while maximising your deductible investment debt. By structuring your loans correctly, you can use borrowed funds to pay for all tax-deductible expenses, freeing up your own cash to attack your private debt.

The need for strict separation of loans is crucial here. To see why, imagine you have a single $200,000 loan facility that you used to borrow $100,000 for a home extension (private debt) and $100,000 to buy shares (investment debt). If you make a $20,000 repayment, the bank will consider half of that repayment ($10,000) to have reduced the private portion of the loan, and half to have reduced the investment portion. You have unintentionally paid down your ‘good’ tax-deductible debt.

Now, imagine you had two separate loans of $100,000 each. You could direct the entire $20,000 repayment to the private home loan, reducing it to $80,000. Your tax-deductible investment loan would remain at $100,000, allowing you to claim the maximum amount of interest as a deduction.

To claim a deduction, you must be able to show the Australian Taxation Office (ATO) that the borrowed funds were used for an income-producing purpose. The easiest way to do this is with separate, clean loan statements where every dollar drawn can be traced directly to the purchase of an investment asset. You can read the ATO’s general guidance on claiming interest deductions here.

Prioritising Your Debt Repayment
Here is a common structure used to implement this strategy effectively:

1. Direct all income (e.g., your salary) into an offset account linked to your private home loan. This reduces the interest calculated on your non-deductible debt every day.
2. Pay for all your living expenses using a credit card.
3. At the end of the month, pay off the credit card in full using money from your salary in the offset account.
4. Pay for all investment-related expenses (e.g., council rates, repairs) directly from your investment loan or a line of credit established for investment purposes.

This structure ensures your own cash is focused on reducing your private debt, while your deductible debt is maximised for tax purposes.

There is no need to be tricky when it comes to tax. The ATO has seen every scheme imaginable. As long as you follow the rules and maintain clear records, gearing is a perfectly legitimate strategy. The ability to deduct interest and other costs on income-producing assets has been an accepted principle in Australia’s tax system for more than a hundred years.

So, when should you use negative gearing simply to reduce your tax bill?

The answer is never.

You should only borrow money to buy an asset if you genuinely expect the total return to be greater than your total costs. In other words, the expected income (rent or dividends) plus the expected capital growth must be higher than the interest and other holding costs associated with the investment.

If this fundamental condition isn't met, you will lose money. It doesn’t matter that the loss is tax-deductible. A loss is still a loss. You would literally be better off paying your income tax and putting what's left of your money in the bank.

How much higher should the expected return be? This depends on your personal tolerance for risk, but as a guide, we often suggest that the total expected return (income + growth) should be around 4% higher than the interest rate on your loan. This margin compensates you for the risk you are taking on and the effort involved.

It is absolutely critical to see negative gearing as an investment strategy that has a tax benefit, rather than a tax strategy that has an investment flavour. You should never gear into an investment just to get a tax deduction. Negative gearing only makes sense when you genuinely and reasonably expect the after-tax capital gain to be significantly greater than the accumulated after-tax losses you incur while holding the asset.

Positive gearing is the opposite of negative gearing. It occurs when the income from a debt-financed asset (like rent or dividends) is greater than the interest and other holding costs. This means the investment generates a net profit from day one, even before any capital growth is considered.

While less common with residential property in major cities (where rental yields are often low), positive gearing is certainly achievable, particularly when investing in shares.

For example, consider an investor who borrows money at a 6.0% interest rate to buy a portfolio of established, blue-chip Australian shares. Let's say that portfolio has an average dividend yield of 5.0%. On a pure cash basis, this investment is still slightly negatively geared (5.0% income vs 6.0% cost).

However, the magic of franking credits can change the picture entirely. If those 5.0% dividends are fully franked, their "grossed-up" value (the dividend plus the attached tax credit) is actually around 7.1%. For tax purposes, the Australian Taxation Office sees an income of 7.1% and an expense of 6.0%. The investment is now positively geared, generating a net taxable profit. This strategy allows an investor to benefit from both positive cash flow (after tax) and the potential for long-term capital growth.

A Word of Warning
Positive gearing can improve your cash flow and reduce your risk. However, you must be cautious of products that sound too good to be true.

In the past, we have seen structured investment products marketed aggressively on the promise of positive gearing. In one infamous example from before the Global Financial Crisis, a well-known institution encouraged clients to borrow from one arm of its business at 9% per annum to invest in another arm that offered a "guaranteed" 12% annual return.

What could possibly go wrong? The answer was in the fine print. The "guarantee" was, in fact, discretionary. After a few months, the institution simply stopped the 12% income payments but continued to charge clients the 9% interest on their loans. There was nothing the clients could do but pay the interest and wait years to get their original capital back.

The lesson is timeless: always do your own due diligence, read the fine print, and be deeply sceptical of anything that promises a high return with no risk. If a deal seems too good to be true, it almost certainly is. Sticking with quality, transparent assets like publicly-listed shares or well-located property is always the most prudent path.