How Does Negative Gearing Work in Australia?

Negative gearing. It’s the way to riches, how all Australian billionaires make their money? We all love it, right?

But how does it actually work? Is it the magic path to riches we all think it is?

It’s one of the most widely used tax strategies in the country, yet also one of the most misunderstood. If you’ve heard the term “negative gearing” in the media and found it confusing, here’s a clear breakdown of how it works in practice.

What is Negative Gearing?

When you invest in an asset, that (hopefully) asset generates income, be it in the form of interest, dividends, rent, royalites or capital growth. That income is taxable to the owner of the asset.

You might also incur costs to hold the asset. There might be fees and charges, or the cost might be more substantial. For example, if you own a property, there could be maintenance costs, agent fees, council and water rates, as well as interest costs on money borrowed to purchase the property and even depreciation on assets purchased. Theses are all ‘costs’ for tax purposes.

If the amount of income you receive is less than the expenses incurred, then you are negative gearing your asset. You are generating a tax loss from the investment.

In most other countries, that’s where the story ends. You’re just running a loss-making investment. However, in Australia, investment losses can be offset against your other income, such as your salary or wages. That lowers your taxable income and ultimately, the amount of tax you pay.

Investment Property Example

You buy an investment property that earns rental income. The costs of owning this investment include agent fees, water rates, council rates, strata levies and building insurance.

Then there’s interest on your mortgage, and depreciation, which lets you claim a deduction for the wear and tear on the building over time.

Let’s pick some numbers to illustrate an example, making the following assumptions.

Let’s say you purchased a property for $500,000 in year 1. Here’s what the investment could look like.

So in this example, you’re losing $16,700 per year, but that loss reduces your tax bill by $7,849. That’s helpful, but it only tells half the story.

The real benefit of negative gearing in Australia is the interaction between deductible losses now and discounted capital gains in the future.

A capital gain is simply the profit you make when you sell an asset for more than you paid for it. For property investors, this is typically the increase in the property’s value over time. Thus, if you bought your property for $500,000 and sold it for $750,000, your gross capital gain is $250,000.

In Australia, we have a Capital Gains Tax (CGT) discount. If you hold an asset for more than 12 months, you get a 50% discount on the capital gain.

Thus in our property example, your gross capital gain of $250,000 is halved to $125,000. If you’re in the top marginal tax rate, then your tax is $59,375.

So, while your deductions are saving you tax at your full marginal rate, (around 47 cents in the dollar), when you sell your investment property, you’re only paying capital gains tax on half of the profit.

Watch out for Depreciation!

Depreciation is the one thing to look out for if you are negatively gearing an investment.

Back to our property example, an asset that was purchased for $500,000. Over the years you hold it, you claim $100,000 in depreciation for the building and PPE, which could be a valuable tax deduction at the time. However, the ATO reduces your cost base by those claims, bringing it down to $400,000

When you sell for $750,000, your taxable capital gain isn’t $250,000. It’s $350,000, calculated from your adjusted cost base of $400,000.

Does the strategy still work in your favour?

Yes. You claimed that depreciation at 47 cents in the dollar and you’re paying CGT on the new total amount at around ~23.5 cents. However, this is a detail you need to understand upfront, not at tax time.

Depreciation in Numbers

Over the ten year period, you have saved $65,950 in income tax from you rental losses, and paid $82,250 in CGT when you sold. That leaves you with a net tax cost of $16,300 over the life of the investment. The property has made a $250,000 capital gain. You have been claiming deductions at 47 cents and only paying CGT at around 23.5 cents.

That advantage compounds across every year you hold the asset. The longer you hold, the more years of deductions you accumulate at your full marginal rate, and the more capital growth builds up below the CGT discount.

Using the example above, this graph shows how after-tax returns shift across different annual capital growth rates. The compounding effect means small positive differences in growth rate can have the potential to generate long-term wealth.

Policy Changes

Even though negative gearing has been part of the Australian tax system for decades, the conversation around tax reform has recently reignited.

Cost-of-living and housing pressures, budget constraints, and shifting political sentiment have placed negative gearing back in the media spotlight.

While the rules have not changed yet, if you are considering this strategy, it’s worth discussing the implications of any policy changes.

Risks and Key Takeaway

Negative gearing is a strategy where your investment property runs at a loss, which can be used to reduce your taxable income.

Of course, it’s not without its risks:

The property doesn’t achieve expected capital growth, making ongoing losses unviable
Extended vacancy periods
Unexpected repairs
Interest rate increases
Potential upcoming changes to tax legislation

It’s generally best suited to higher-income property investors who can afford the short-term cash flow impact and are focused on long-term capital growth. As with any strategy, it’s important to speak with your accountant or financial adviser to ensure it aligns with your personal circumstances and financial goals.