Negative gearing occurs where the income from a ‘geared’ asset is less than the interest and other holding costs, creating a loss while the asset is held. A ‘geared’ asset is one that is at least partly financed using debt.
Investors can usually offset the loss from negative gearing against other income for tax purposes. This creates a tax benefit, in the form of less tax being paid than otherwise, and this tax benefit in a sense adds to the investment return on the asset.
Negative gearing only makes sense if the investor expects to earn an eventual capital gain greater than the losses incurred while holding the asset, such that overall the investor is better off by making the investment. Bear in mind that capital gains are usually taxable, although there is often a 50% discount which can be had.
When most people think of negative gearing, they think of residential property investment. However, any investment asset can be negatively geared. The key to remember is that the long term prospects for the investment must be good, such that investment makes a decent profit overall. ‘
The following example shows you one way that negative gearing can be applied in the share market.
Agnetha owns a hairdressing salon which earns her about $100,000 a year after expenses. Her marginal tax rate is 37%. Agnetha owns one home, valued at $600,000. She has a debt of $200,000 on this home, meaning she has $400,000 in equity. Here is how her assets look:
| Home: | $600,000 |
|---|---|
| Loan: | $200,000 |
| Equity: | $400,000 |
Agnetha decides to make some share market investments. She comes to see us and we discuss the benefits of dollar cost averaging into an index fund. (We won’t go into the details of that here). Agnetha decides that she will establish a line of credit loan against her home to the value of $200,000. She will use this to make a series of monthly purchases of units in an index-tracking Exchange Traded Fund (ETF). At the end of two years, she has purchased $200,000 worth of units (including brokerage). Her net assets now look like this:
| Home: | $600,000 |
|---|---|
| Units in ETF: | $200,000 |
| Total Assets: | $800,000 |
| Home Loan: | $200,000 |
| Investment Loan: | $200,000 |
| Total Debt: | $400,000 |
| Equity: | $400,000 |
Her preferred ETF pays a distribution that is equal to 4% per year. This equates to $8,000 per year on the holding. The interest rate is 6%. This equates to $12,000 in interest payable. Agnetha therefore makes a ‘loss’ of $4,000.
Agnetha’s marginal tax rate is 37%. This means that her income tax reduces by $1,480 as a result of the $4,000 loss (37% of $4,000 is $1,480). The after-tax loss on the investment is now $2,520. This is 1.26% of the amount she has borrowed – meaning that if her investment rises by more than this, the capital gain will more than offset the short-term loss. However, the capital gain is taxable, at a discounted rate if Agnetha holds the investment for more than 12 months. In order for Agnetha to make a profit after CGT, the capital gain needs to be 1.55% per year.
This is lower than the current inflation rate, meaning that Agnetha will make a profit if her investment (which has been bought over an extended period) keeps track with inflation.