This is the second post in our ‘Getting your strategy right’ section of the Everyday Property Foundations series and I’m sure it will be a popular one. After all, who doesn’t want to own property that actually makes you money? Our post today will look at positive gearing and positive cashflow property, including what these terms mean, the pros and cons and where or how these properties can fit into your investing strategy.
What is Positive Gearing
We’ve previously looked at negative gearing and we determined that a negatively geared property is one where the rental income is less than the expenses and interest on borrowings. A negatively geared property is one that makes a loss and this loss is then able to be offset against your taxable income.
A positively geared property is pretty much the opposite of this. It is a property where the rental income exceeds the expenses and bank interest payable and therefore the property is making a profit. The profit from a positively geared property must be declared as part of your taxable income and therefore you will pay tax on this profit.
So basically, it comes down to this:
- You buy a property
- The income from the property exceeds the expenses (including interest) from the property
- You are making a profit
- This profit is included as your taxable income for the year
This is where the waters can get a little muddy in terms of definitions and terminology. Many investors will recognise a distinction between a positively geared property and a positive cashflow property and so we’ll define a positive cashflow property here.
Sometimes when an investment property is negatively geared but the investor is able to claim a lot of on-paper tax deductions for a property, then these deductions can be enough to see the investor receive a taxation benefit that actually exceeds the cost of the property. This means the overall effect is that the property generates a positive cashflow, putting money into your pocket!
So basically, it comes down to this:
- You buy a property
- The expenses and interest from the property exceed the rental income
- There is a loss on the property
- You are able to claim on-paper deductions for the property
- The tax saving to you is greater than the loss made on the property
- You receive cash back as a result; hence it is positive cashflow
Additionally, you can elect to receive this cash back throughout the year by varying your PAYG withholding via the Australian Taxation Office. So rather than wait until the end of the tax year to receive your tax benefit, you can elect to forecast what this taxation effects of your investment will be and reduce the amount of tax in your regular PAYG income, effectively giving you more money in your pocket each payday.
In both cases, positively geared property or positive cashflow property, the overall effect is a positive cashflow to you, the investor, so from here in, we’ll simply refer to ‘positive cashflow’ to cover both of these terms.
The Advantages of Positive Cashflow
Well you don’t have to think too hard to come up with the major benefit of a positive cashflow investment. It’s err…well…positive cashflow. This is, of course, a great thing because not only are you making a profit but it means that you are still able to maintain and potentially even improve your borrowing potential. When you think of negative gearing property, you can see that at some point your borrowing capacity will be limited by your ability to support the expense of owning the property. But with positive cashflow property, this limit on borrowing capacity is not an issue. You may use the profits of your positive cashflow properties to live off or to reinvest. And of course, if your investment location is well chosen and/or you have a bit of luck on your side then you may also experience capital gain on your property— now there’s a win-win for you.
The Disadvantages of Positive Cashflow
Positive cashflow properties can be harder to find than negatively geared properties. There was a time (well before my investing career, that’s for sure) when positive cashflow properties were abundant in some areas, but that time has well passed. Nowadays you have to look harder or think smarter. You may need to think creatively in order to manufacture a positive cashflow situation.
Traditionally when people have looked for and thought of positive cashflow properties then these properties have often been in regional locations rather than the capital city locations. The issue there may be that these regional locations may experience slower capital growth. Of course this is not always the case; however, it’s worth looking closely at capital growth history and potential for future capital growth before jumping on that high yielding property in the middle of nowhere! If going for purely cashflow positive properties is your aim, you need to think about how you plan to make your money in property— if the plan is to build enough passive income on which you can retire, then you really need to have properties that are substantially positive or you’ll need to own a lot of properties.
The other ‘con’ that people often mention is that you’ll need to pay tax on your profit. Personally, I don’t have a problem with paying tax on my profit. It means I’m making money…surely, that’s a good thing!
Why would you use positive cashflow in your portfolio?
Balance. Owning several negatively geared properties can be a difficult thing to sustain— it is a drain on your income and depending on what that income is, this can really impact upon your lifestyle. Being able to balance out your portfolio with a mix of negatively geared and positively geared property can be a sensible course of action.
Passive Income. Some investors elect to only include positive cashflow properties in their portfolio and can even look to creating sufficient passive income on which they can retire from their ‘job’.
Growth. Whether the properties you buy are negatively geared or positive cashflow you should always be making educated and intelligent choices about the locations in which you choose to invest and the properties you choose to own. These choices should be about maximising the potential for capital growth. It is the leverage obtained from capital growth that can really build your wealth.
Positively gearing is where the income related to your rental property exceed the expenses, including interest, so you are making a profit. Another means of generating a positive cashflow property is where a property may have sufficient on-paper tax deductions to provide a taxation saving so that, when coupled with the rental income of the property, the overall effect is a property that provides a positive cashflow for the investor.
- You are making a profit each month
- Doesn’t limit your borrowing capacity, can continue to service more properties
- Can live off or invest the profits
- Can experience capital growth in addition to the income from the property
- Harder to find than negatively geared property
- You may need to be creative to generate a positive cashflow situation
- Can be in areas of slower capital growth
- You pay tax on your profits
What do I think?
Positive cashflow property…hmm…let me see…yes, please! I love this concept; however, I also think that it’s very important to think about your strategy when you say you are looking for positive cashflow property. Holding a few properties that earn you $10 a week in areas with limited capital growth isn’t what you want to aim for, so you need to think about whether your plan is to build your portfolio for growth or your to build passive income on which to retire. The timeframe in which you want to achieve these goals is also a big consideration and will drive the strategy and types of deals which you will need to do.
Positive cashflow property can really make the difference for many investors between stalling their portfolio at 2 or 3 properties and really going on to create their ‘empire’! Of course, no matter what your strategy is, you can always look at the properties you own or wish to buy and think creatively how you can increase the yield on those properties to generate the optimal cashflow situation.