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Positively Geared Versus Negatively Geared Investments

If you ask a property owner if they have ever heard of negative gearing, the answer would probably be yes. They might tell you that negative gearing is great since you can lower your tax liability, whilst the investment is still achieving capital growth. What they might not know is that a negatively geared investment also carries an intrinsic risk, which is that it has an impact on the investor's net cash flow. The investor’s cash flow is reduced, which could likely restrict the investor’s lifestyle until they realise the desired capital growth in the investment.

 
Example 1
 
 
Mister and Mrs Smith purchase an investment property at $300,000 in 2001. They borrow $250,000 and have to come up with an extra $10,000 per year to cover interest which is not covered by the rent the property is generating. Negative gearing allows them to receive approximately $3000 back in tax p.a. At the end of 2008 they have lost approximately $56,000 in net interest payments to the bank, while the house has increased in value to $400,000. Their profit (net gain) after the $56,000 interest payments and capital gains tax (not including strata and other utility expenses along the way) is approximately $35,000.

If you ask the same property owner whether they have heard of positively geared investments, they might not be so familiar with the term.

A positively geared investment differs from a negatively geared investment in that it does decrease, but rather increase the investors cash flow. Positively geared investments tend to provide lower capital growth over the long term, but at the same time provide a lower risk to the investor because they are virtually self-sustaining. The problem with a positively geared investment is that it creates a larger tax liability for the investor.

Combining the two investments however can create large capital growth with a cash flow neutral investment.
 
Example 2
 
 
Mr and Mrs Smith borrowed $300,000 at 10% and invested into an equity income fund which is capital protected, and has returned about 14% per annum in the income on average for the last 10 years. The investment has a net positive return of $12000 per year. They then purchase the property as mentioned in the previous example, which has reduced their positive return to $2000 per year. However the capital growth from both the property and the income fund has net of them a combined return of $130,000 over the seven-year period! Add to that the $2000 per year pre-tax they have been receiving and this pushes up the return to over $140,000!

They've also done this without any negative impact to their cash flow, which means that if one of them had lost their job or if they had had children, this would not they would not have increased their chance of losing the investment, or struggling to make the repayments on their investments.