What Is Negative Gearing In Real Estate Investing?
“Negative gearing” is when rental income revenue (R) is less than expenses (e.g. maintenance costs [M] and mortgage interest [I]):
In other words:
R-(M+I)<0
Alternative negative gearing equations also take into account other possible expenses such as council rights, insurance, etc.
The result of negative gearing:
The property costs more each year than the money that comes in from tenants. It sounds undesirable, but actually, in certain situations, an owner can turn a handsome profit on a property that is consistently negatively-geared.
There is also positive gearing, in which we reverse the ‘<’ sign to ‘>’:
R-(M+I)>0
In positive gearing, the owner turns an immediate profit.
Finally, in neutral gearing, those < and > signs become =. The income the property generates is neither a net asset nor a net liability. Obviously, very few properties are perfectly neutral all the time, so true neutral gearing is exceedingly rare.
R-(M+I)=0
What Are The Pros And Cons Of Negative Gearing?
Pros:
- Tax benefits: You can deduct each year’s losses from your income taxes. The Japanese government generally allows this as long as it doesn’t involve a partnership or bad debts. Bad debts include gambling debts, etc.
- Capital appreciation: Even if the piece of real estate logs a net loss every year, if its market value goes up… …then when the owner sells it… …the result can make a net profit.
Cons:
- There needs to be capital appreciation. Otherwise, it’s a loss.
- Capital gains tax (CGT): long-term capital gains tax is currently 22.1%. Short-term capital gains tax is even higher. If you profit on the sale of the piece of real estate, you’ll need to pay CGT.
- It requires you to keep paying money until you sell. You could go a decade or more just paying out-of-pocket until that one glorious day on which you sell. It requires you to already be somewhat financially secure, and have excellent delayed gratification.
Examples Of Positive, Neutral, And Both Good And Bad Negative Gearing
In all of the following examples, let’s assume that the real estate investors spend 1% of the home’s purchase price on maintenance, repairs, and renovations.
To illustrate these concepts, imagine this: Oliver, James, Jack, and John are good friends. They each invest ¥10 million in real estate somewhere in Japan. They each put ¥2 million down, and their mortgages’ interest rates are all 1.5%. Every month, each man is paying ¥25,000 in interest. Each also pays, on average, ¥8,333 on maintenance, repairs, and renovations (¥33,333 total). Per year, this is ¥399,996 in maintenance+interest, but for the sake of simplicity, let’s round that up to ¥400,000.
Oliver bought his building (likely a one-room) in the 23 Special Wards of Tokyo. His tenant pays him ¥550,000 in rent per year. This means his profit every year is ¥150,000. Oliver is “positively-geared.”
James bought his building in Osaka. His tenant pays him precisely ¥400,000 in rent per year. He neither profits nor loses anything. James is “neutrally-geared.”
Jack bought an old farmhouse in Tottori (鳥取, the smallest prefecture by population). He struggles to find tenants. He averages ¥350,000 in rent per year. His R-(M+I) is -¥50,000 per year, so this is a clear case of being “negatively-geared.” Oh, Jack, why did you have to go and do that? What’s worse, as more people move from the countryside to the city and the structure ages, it’ll probably lose value. At least there’s a silver lining, though. He can write off ¥50,000 each year from his income taxes. However, this hardly justifies spending ¥10 million on what is essentially a liability.
Finally, meet John.
John did the same thing as Jack, pretty much. He bought a property (in the year 2020) that only brings in ¥350,000 in rent per year. It has ¥400,000 in expenses. However, unlike Jack’s Tottori farmhouse, John’s property is in an appreciating part of Tokyo. How did Jack know the value would go up? Who knows. Perhaps he had a secret meeting with time travelers from the year 2030.
Anyhow, each year, his property’s market value increases by approximately 5%. After ten years, his property is worth over ¥16 million. Although he lost ¥5 million in the R-(M+I) equation over the course of ten years… …his property gained ¥6 million in value. John then sells his property for ¥16 million. In the end, the whole endeavor generated ¥1 million in profit. Oh, and, he got to deduct ¥50,000 each year from his income taxes. Certainly the time travelers from the year 2030 could’ve told him some more useful information. They could’ve told him who would win the World Series in 2025, but oh well, at least he profited.
What Is Negative Gearing In Real Estate Investing? Conclusion
Negative gearing is when expenses (mortgage interest plus maintenance, and maybe other expenses, too) exceed rental income. Of course, most real estate investors dream of a property that immediately generates profit. However, that’s not to say that negative gearing is always bad. Negative gearing has tax advantages (yearly deductions) and capital appreciation can offset losses, especially in a booming real estate market. Unless you really know what you’re doing, don’t attempt this in Japan, though. Although capital appreciation certainly can happen, holding the property and receiving rental income is a more reliable path to profit.
