We’ve talked about the differences between positive cash flow and negative gearing. Let's have a look at how this might work in practice.
An example of positive cash flow
Chris is a hairdresser—a chopper of considerable talent. He started out as an apprentice and worked his way up. A couple of years ago, he went out on his own and started up 'The Do'—a thriving salon on a busy shopping strip.
Over the past decade, Chris has steadily saved a $170,000 deposit to buy an investment property. He looked for ages, just missed out at a couple of auctions—but then saw the perfect inner-city apartment. He took the plunge and used his $170,000 as a (40%) deposit towards the $425,000 cost.
He found tenants easily enough, and now the property generates $2,000 rent a month. The mortgage plus other expenses total $1,000 per month. For Chris, that’s $1,000 of positive income a month (or $12,000 per year).
To calculate the yield, dividing $12,000 by Chris's initial $170,000 investment results in a 7.05% return.
This is a positive cash flow.
An example of negative gearing
Reveka's a builder. She doesn’t own a business, but works for someone else.
Over the years, she’s saved up enough money to buy a trendy apartment in a slowly-gentrifying outer suburb as an investment. The existing tenants pay around $20,000 a year in rent.
Reveka started out with a 15% deposit. This means she’s highly geared (in debt) and is facing a large annual interest bill of $25,000. She has around $4,000 in expenses, too—rates, insurance, body corporate fees, repainting the front room, fixing the garage door and so on.
Overall that’s a loss of $9,000 a year which affected her pre-investment purchase lifestyle. This isn’t as bad as it seems. Reveka could use this $9,000 loss to reduce her taxable income, thus reducing her tax bill. However, the tax rebate on this loss would only get realised at the end of the financial year, unless she applies to have her PAYG withholding varied.
Assuming that Reveka can offset the $9,000 against her taxable income, with her tax rate at 33 per cent, this brings her tax bill down by $3,000. Now her out-of-pocket costs are only $6,000.
Given her ultimate goal of long-term capital growth, Reveka's comfortable making a $6,000 loss each year.
This is an example of negative gearing. It’s a more complicated investment strategy, certainly.
Before you decide which strategy is best for you, talk to a professional. A financial adviser or accountant is a good place to start.