DEFINITION of Negative Gearing
Negative gearing is a form of financial leverage and is commonly used in the context of property investing. Negative gearing involves borrowing money to buy an income producing asset, such as a rental property, when the asset won't be able to produce enough income to cover the loan payments, cost of maintenance, interest, or depreciation in the short term. Ideally, the asset will eventually produce enough money to cover those costs. These losses can be beneficial to the owner's tax bill in certain instances. Depending on the investor's home country, the shortfall between income earned and interest due can be deducted from current income taxes. Countries that allow this tax deduction include Canada, Australia and New Zealand. Investing in such a way might make sense in instances where large capital gains are expected at the time of sale which make up for the intermittent losses.
BREAKING DOWN Negative Gearing
Negative gearing occurs when an investor purchases an income producing asset using a loan, and the income produced by the asset cannot cover the loan payments or other expenses associated with the asset. Negative gearing most often occurs in rental properties, where the rental income received isn't enough to cover the loan payments, interest costs on borrowings, plus expenditures toward property maintenance and upkeep.
Negative gearing only becomes a profitable venture when the property is eventually sold, and a prerequisite is that property values are rising, not falling or holding steady. If property values are falling or holding steady, it is difficult to sell the asset for the gain necessary to make up for the losses while the asset was held and not producing income to cover expenses. Many investors who speculate this way will purposely seek out negative gearing for the tax deductions in the hope that they will make a profit when the property is sold for a capital gain.
Investors considering this type of arrangement need to have the financial stability to fund the shortfall out of pocket until the property is sold and the full profit can be reached. Also of utmost importance is that the interest rate is locked in from the beginning or, if the borrower's interest is calculated on a floating index, that prevailing rates remain low.