Negative gearing is where borrowed funds are used to invest in either property or shares and the income generated (at least in the short term) is less than the tax deductible expenses.
This creates a taxable loss from the investment which may be offset again the taxpayers other income (normally salary and wage income). This results in the salary and wage earner receiving a tax refund of part of the PAYG withholding tax they have had deducted from their wages over the year.
This is a profitable strategy if the investment grows in value (capital appreciation) each year, by an amount that is greater than the taxable loss less the tax refund received, less the depreciation claimed.
The strategy works best when the investments purchased produce stable income and steady capital appreciation each year.
The risks involved when borrowing to invest include:
- Income risk – The taxpayer loses their job or income source and cannot fund the taxable loss.
- Capital risk – The investments purchased fall in value or just stay constant.
- Investment income risk – The investment doesn’t produce the expected investment income, i.e. the rental property becomes unrented, or the dividend paying shares stop paying dividends.
- Interest rate risk – Interest rates on the loan could rise.