How do both strategies work?
In our article Positive cash flow vs. negative gearing, we explained the difference between each gearing strategy. Now, let's look at the case study that will help explain how they might work in practice.
An example of positive cash flow
Chris is a talented hairdresser. 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 a long time, 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 in 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, let’s divide $12,000 by Chris's initial $170,000 investment. The result? A 7.05% return.
This is a positive cash flow.
An example of negative gearing
Reveka is 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 – including rates, insurance, body corporate fees, repainting the front room, and fixing the garage door.
Overall that’s a loss of $9,000 a year, which affected her pre-investment purchase lifestyle. But this isn’t as bad as it seems.
Reveka could use this $9,000 loss to reduce her taxable income – and by extension – reduce 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).
With her tax rate at 33 per cent, let’s assume that Reveka can offset the $9,000 against her taxable income. 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. While it’s a more complicated investment strategy, it can be a solid long-term option.
Even if you have plenty of equity, it’s not a given that you can borrow against it. The bank will take into account factors such as your income, your age, how many kids you have, and any additional debts.
Remember to play it safe. If you don’t have any funds outside your home equity, then it’s risky to use every last cent of your usable equity to invest in property.
You always need a buffer – back up funds in case things don’t go to plan. Even if it means you can’t invest for a while, it’s important to keep yourself protected.
Before you decide which strategy is best for you, talk to a professional. A financial adviser or an accountant is a good place to start.
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The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, financial and taxation advice before acting on any information in this article.