Why Be So Negative About Negative Gearing?

By Michael Yardney

One topic guaranteed to cause a strong reaction in the media is negative gearing.

And it's been hitting the headlines again with both sides of politics weighing into the argument this time.

The problem is that many people with only a hazy idea of what it actually is, blame negative gearing for virtually everything from locking first home buyers out of the market, to causing high property price rises, to ugly greedy investors rorting the tax system and driving the National Budget into deficit.

Indeed, the reaction to negative gearing has been so, well, negative, that there been some calls for it to be scrapped and Labor says it will do so if elected and the Liberal Party is looking at tinkering with it.

But is negative gearing really that bad?

Firstly, a quick primer:

A property is negatively geared when the costs of owning it – interest on the loan, bank charges, maintenance, repairs and depreciation – exceed the income it produces.

Since the costs of producing an income are generally deductible against the taxpayer’s other income, property investors can effectively offset some of the interest expense against their wages.

This has made some argue that other, less fortunate taxpayers help these property investors meet their costs.

Now negative gearing is nothing new, it was first introduced with the Income Tax Assessment Act in 1936.

But let's make things clear - negative gearing is not

 (or maybe I should put it differently - should not be used as) a property investment strategy. It's just a result of how a property has been financed.

So it’s never been a reason to invest in real estate, even though some misguided (or self interested) advisors have recommended it as such.

Why would anyone go into a business deal that is expected to make a loss?

Generally it’s because property investors hope that their income losses will be more than offset by their capital gains (the growth in the value of their property) that they can access when they refinance or eventually sell their property.

Alternatively, a negatively geared property may become neutrally or positively geared as the rental increases, but in the main, negative gearing really only makes sense from an investor’s viewpoint if property increases in value.

And in Australia this capital gain is not taxed unless you sell your property, and then it is concessionally taxed; again evoking the argument that it favours wealthy landlords.

Of course negative gearing is more favourable for taxpayers who earn high incomes.

Imagine an investor had excess interest expenses of $10,000.

If they were on a marginal tax rate of 15 cents in the dollar they could use their loss and reduce their tax by $1,500. But to a taxpayer in a higher tax bracket, one who pays 30 cents in the dollar tax, they could reduce their tax by $3,000.

So the benefits of negative gearing are greater the more you earn and the higher your tax rate.

What gets some people hopping up and down is that Australia’s negative gearing regulations are different to most parts of the world in that they allow investors, in both property & shares, to write-off the cost of borrowing used to acquire the asset in addition to other holding costs against all sources of income (including the investor’s personal wages) and not just the income generated by the asset.

And in contrast to most other countries, in Australia there are no limitations on tax payers’ income (in other words negative gearing works for billionaires as well as average income earners), on the size of losses, or the period over which losses can be deducted, which makes some suggest they're a great tax shelter.

But negative gearing is not just for the rich

However the assertion that all negatively geared property investors are ‘ugly wealthy Australians’ is simply unfounded and incorrect.

According to the latest ATO info there are just under two million property investors in Australia, of whom two thirds (1.3 million) negatively gear.

Interestingly, these investors do not predominately come from the wealthy end of town.

Indeed, 70 per cent of negatively geared investors earned less than $80,000.

Less than 6 per cent were in the top tax bracket.

Fact is using the benefit of negative gearing investment has allowed many ordinary working class Australians to invest in property and to take control of their financial destiny.

Source:

Herald Sun; ATO.

Property investors provide an essential service
I would argue that property investors provide an essential service to millions of Australians who chose to, or have to, rent their accommodation and as such these investors should be treated like all other business people.

In our modern society we pay taxes and expect the government to provide us with certain essential services.

These include hospitals, roads, schools, jails, public transport, aged care and public housing.

In Australia the government often shares the burden of providing these services with private enterprises that can often deliver them more efficiently and cheaper.

When the government can’t supply enough public hospital beds, private run hospitals step up to the mark and not only receive tax deductions for their business loans, but also allowances to subsidize them.

So do aged care providers, schools and public transport providers who provide services in tandem with the government.

Our government also provides public housing, but not enough for all those who can’t afford to buy their own property.

While government social and public housing programs are helpful, it is only the private rental market that can deliver rental accommodation at the rate and scale that is required at present.

Property investors save a deposit, buy a property, commit to a loan for 25 or 30 years and provide accommodation for others in our community.

In return we expect to get a reasonable return on our investment risk, just like other business people do.

We know that the rent won’t cover our expenses, but accept that certain tax benefits plus the long term capital growth will make up for this.

Sometimes it does, and sometimes it doesn’t.

What if the government removes negative gearing?

Leverage and negative gearing compounds returns in the good times, but multiplies losses when property prices are flat or falling.

I know as many people who have lost money in property investment as those who have made money.

Much like most other small business people.

If the government takes away my tax concessions, I would have to consider my investment options.

To ensure I get a decent return I’d put up my rents if I could, or maybe I’d invest elsewhere to get the best bang for my bucks.

The result would be that rents would rise and tenants would have to fight over the few rental properties left, or the government would have to invest its own money and buy or build properties and enjoy the pleasures of being a landlord.

Of course the government already provides some public housing, but not enough, leaving the task of providing rental accommodation not only in our capital cities, but also in regional Australia and in the remote mining towns to private investors.

People like you and me have chosen to run our own little property investment businesses.

If I set up a dog wash business or a restaurant, I’d be able to claim a tax deduction for legitimate business expenses including loans to set up our business or purchasing business equipment.

Why should it be different for property investors who take on a business risk?

Doesn’t negative gearing push up property values?

To say negative gearing has pushed up property prices is a smoke screen.

Just look what happened to property prices overseas in countries like the USA and parts of Europe where negative gearing isn’t allowed.

They experienced a boom and a subsequent bust of much greater magnitude that we have gone through.

What these lobbyists may not recognise is that borrowing in order to undertake productive investment actually helps economic growth because value is being added.

After all, there will always be some investments that have lower returns than the interest expenses on the loans taken on to acquire them.

This economic reality has nothing whatsoever to do with tax.

For example a typical property investment may start off with a large loan and lowish rent. As time goes by the loan is paid down and the rent increases.

Overall the investor makes a profit and the tax office gets its share of this.

Actually, there is not as much loss of revenue to the authorities as some critics believe because for every dollar of interest claimed as a tax deduction by a borrower there is a corresponding dollar of interest assessable to a lender.

But that’s not all…

If the governments stops the availability of negative gearing benefits the danger arises that there may be unintended consequences.

It is possible that even following a positive cash flow strategy you end up negatively geared and suffer.

What if:

• Interest rates rise after you buy your investment?
• Rents fall or your property becomes vacant for a period of time? Or
• You have to undertake a major repair of your investment property.

To deny the person making commercial a loss like this a tax deduction would be to inflict a double whammy on them and increase their hardship unduly.

In conclusion:

Any reduction in negative gearing benefits would significantly reduce rental investment in both new and existing properties and would worsen rental affordability through a reduced supply of investment housing.

A reduced rental supply means lower rental vacancies and increased rents.

Property investment is a real and effective method for bolstering the savings of middle Australia at the same time providing accommodation for those who the government can’t or won’t help and should remain as is.

ABOUT MICHAEL YARDNEY

Michael is a director of Metropole Property Strategists who create wealth for their clients through independent, unbiased property advice and advocacy. He's been voted Australia's leading property investment adviser and his opinions are regularly featured in the media. Subscribe to his blog at Property Update.