Many Australians are comfortable with the idea of using debt to fund investments like a rental property, a share portfolio or units in a managed fund. It’s the sort of debt I call ‘effective debt’ because it can be a useful tool for building personal wealth. But don’t let the prospect of negative gearing draw you into an investment that doesn’t stand on its own merits.
Negative gearing is a concept that‘s frequently bandied around when it comes to investing. To understand exactly what it means, let’s break the term down into its component parts.
‘Gearing’ means borrowing to invest. Used wisely, gearing can beef up your investment returns and allow investors to purchase high value assets they wouldn’t otherwise be able to afford, like a rental property.
An investment is said to be ‘negatively geared’ when the costs of owning the asset, including interest on the loan used to buy it, outweigh the returns it generates. For example if a rental property delivers annual rent worth $20,000, but its running expenses including mortgage interest come to $30,000 each year, it is negatively geared to the tune of $10,000 annually. This figure, which represents a loss, can usually be claimed on tax, and this is where the appeal of negative gearing lies.
The problem is that many people become irrationally excited about the tax savings of negative gearing. Let’s be quite clear on this – a loss on an investment may reduce your tax, but it is still a loss, and the whole point of investing is to make money and build wealth. Yet I often hear people justify a dud investment with the claim “but it’s a tax deduction”.
The bottom line is that tax breaks should never be the main motivation to invest. If an asset is only generating a return of 4% and you’re paying 6% interest on the underlying loan, the investment is not building your wealth. Over time it will do little more than deplete your wealth unless it is also providing decent capital growth over time.
An additional pitfall of gearing is assuming the investment will generate sufficient income to meet the loan repayments. This can be a dangerous assumption because it doesn’t always happen. Companies can – and do – scale back dividend payouts or elect not to pay them altogether. Rental properties inevitably experience periods of vacancy, and the cash flow that may have made a significant contribution to the loan repayments can quickly diminish or dry up altogether. In the meantime, your lender still expects to be repaid.
This is why you need to be confident your other sources of income such as wage or salary payments will cover the loan repayments when the asset doesn’t.
If you are considering a quality investment that suits your long term goals, tax benefits should be seen as icing on the cake. But a tax deduction alone is not a good enough reason to invest.