What is Negative Gearing?

Legal Definition
Negative gearing is a practice whereby an investor borrows money to acquire an income-producing investment property and expects the gross income generated by the investment, at least in the short term, to be less than the cost of owning and managing the investment, including depreciation and interest charged on the loan (but excluding capital repayments). The arrangement is a form of financial leverage. The investor may enter into such an arrangement and expect the tax benefits (if any) and the capital gain on the investment, when the investment is ultimately disposed of, to exceed the accumulated losses of holding the investment.

Tax treatment of negative gearing would be a factor that the investor would take into account in entering into the arrangement, which may generate additional benefits to the investor in the form of tax benefits if the loss on a negatively geared investment is tax-deductible against the investor's other taxable income and if the capital gain on the sale is given a favourable tax treatment. Some countries, including Australia, Japan and New Zealand allow unrestricted use of negative gearing losses to offset income from other sources. Several other OECD countries, including the US, Germany, Sweden, and France, allow loss offsetting with some restrictions. In Canada, losses cannot be offset against wages or salaries. Applying tax deductions from negatively geared investment housing to other income is not permitted in the UK or the Netherlands. With respect to investment decisions and market prices, other taxes such as stamp duties and capital gains tax may be more or less onerous in those countries, increasing or decreasing the attractiveness of residential property as an investment.

Another example of is borrowing to purchase shares whose dividends fall short of interest costs. A common type of loan to finance such a transaction is called a margin loan. The tax treatment may or may not be the same.

Negative gearing is a form of leveraged investment. In a few countries, the strategy is motivated by taxation systems that permit deduction of losses against taxed income, and tax capital gains at a lower rate. When the income generated covers the interest, it is simply a geared investment, which creates passive income.

A negative gearing strategy makes a profit under any of the following circumstances:

  • if the asset rises in value so that the capital gain is more than the sum of the ongoing losses over the life of the investment
  • if the income stream rises to become greater than the cost of interest (the investment becomes positively geared)
  • if the interest cost falls because of lower interest rates or paying down the principal of the loan (again, making the investment positively geared)

The investor must be able to fund any shortfall until the asset is sold or until the investment becomes positively geared (income > interest). The different tax treatment of planned ongoing losses and possible future capital gains affects the investor's final return and leads to a situation in countries that tax capital gains at a lower rate than income. In those countries,it is possible for an investor to make a loss overall before taxation but a small gain after taxpayer subsidies.

Deduction of negative gearing losses on property against income from other sources is permitted in several countries, including Canada, Australia and New Zealand. A negatively-geared investment property will generally remain negatively geared for several years, when the rental income will have increased with inflation to the point that the investment is positively geared (the rental income is greater than the interest cost).

Positive gearing occurs when one borrows to invest in an income-producing asset and the returns (income) from that asset exceed the cost of borrowing. From then on, the investor must pay tax on the rental income profit until the asset is sold, when point the investor must pay capital gains tax on any profit.
-- Wikipedia