Positive Gearing Explained (For Dummies)
What is positive gearing and how does it differ from negative gearing and positive cash flow? In this article I explain exactly what positive gearing is. I will also explain what negative gearing, positive cash flow and neutral cash flow are.
There are many pros and cons to investing in different types of real estate. But first you must understand the definitions of different types of investment properties first. All these terms relate to how a property affects your cash flow on an ongoing basis.
What Is Positive Gearing?
Positive gearing definition – Positive gearing occurs when the gross income generated by the investment is more than the cost of owning and managing the investment, including interest charged on the borrowings (payments reducing the principal component of borrowings is not included as a cost). The investment generates a positive cash flow before and after taxation is taken into account.
Positive gearing explained (in normal english) – I understand that formal definitions can sometime be confusing, so let me make it a bit easier for you to understand.
Let’s say you own a house (it doesn’t matter how much it cost). Every month it brings in $1,000 in rental income and every month you pay $800 in property expenses.
At the end of each month you have $200 in cash left over (before tax) and after tax you will still have more than $100 left over (maximum tax rate is 45% not including Medicare levy or surcharge).
Because the property generates you excess cash before and after tax it would be considered a positively geared property.
What Is Negative Gearing and How Does It Differ From Positive Gearing?
Negative gearing definition – Negative gearing is a form of financial leverage where an investor borrows money to invest but the gross income generated by the investment is less than the cost of owning and managing the investment, including interest charged on the borrowings. The investment generates a negative cash flow.
Negative gearing explained – Let’s use the same example above to make negative gearing 100% clear.
Let’s say you own a house (it doesn’t matter how much it cost). Every month it brings in $1,000 in rental income (same as above example) BUT let’s say this time it costs you $1,200/month in property expenses.
In this case as the end of each month you would have -$200. This means you would have to find $200 from somewhere else (probably income from your job) to pay for this ‘debt’.
Assuming no depreciation (depreciation explained) before tax you would have lost money ($200) and after tax you would have lost money (~$200-$110 depending on your tax rate).
Because the property costs you money before AND after tax it is considered to be a negatively geared property.
What About Positive Cash Flow? Is That Different?
Positive cash flow IS different to positive gearing.
Let me explain.
Let’s say we use the above negatively geared example where you earn $1,000/month but pay out $1,200/month.
Before tax you are losing $2,400/year.
Let’s say your tax rate is 30% and you can claim deprecation of $10,000 on this property (if this is confusing watch this video). Your total (on paper) loss for the year would then be $12,400. The actual cash lost plus the depreciation.
When doing your tax return left’s say you are entitled to 30% back on the total loss of $12,400. You would get a tax refund of $3,720.
So you paid out $2,400 but then you got back $3,720. So you actually profited $1,320.
So BEFORE tax you LOST money, but AFTER tax you MADE money.
This is the definition of positive cash flow in most circumstances.
Positive Geared Properties Are Also Positive Cash Flow
Stick with me here because this can seem confusing.
A positive cash flow property is really “a property that generates income after tax in taken into account”.
Because both “positive cash flow” and “positive geared” properties generate an income after tax (even though positive geared generates an income before tax as well) they are both considered to be positive cash flow.
That is why these terms are often interchangable.
Lastly, What Is Neutral Cash Flow
Neutral cash flow is when you don’t make a profit and you don’t incur a loss. You simply break even.
When most people discuss neutral cash flow they don’t specify whether or not it is calculated before or after tax.
It is very rare for a property to break even EXACTLY. However, many people will call a property “neutral” if the income or loss is considered insignificant. (eg. A profit of $7.85 on a property worth $500,000 would be considered insignificant and probably called a neutral cash flow property by most people.)