Being positive about negative gearing

I'm starting to see rumblings in the media once again about this often talked about tax policy so I thought it timely the concept is reviewed to look at some of the home truths about its pros, cons and where it’s heading.

Firstly, what is negative gearing? Simply put, negative gearing is the ability of an investor to deduct investment losses against their personal income. To see exactly how this works using the numbers and why no one should actually be investing to negatively gear a property, read my article on our website about saving tax. Most investors understand the basic concepts of negative gearing and although some aspects to it are a little more complicated than others, for the sake of brevity I will assume that anyone reading this article already has a general understanding.

So, why do we have it?

As with any tax policy, it is not necessarily designed to simply give people free money – there has to be a social benefit. Although it is a hotly contested issue (and whether or not you agree if the following works), given that it already exists we can generally accept the following to be aims of why it was introduced in the first place:

• Reduced pressure on the public housing system. Private rentals account for approximately 27% of the property market and 3% in public housing. Negative gearing is designed to encourage private investment in the housing market to reduce the pressure on the government having to fund public housing. Part of the theory is that the tax amount the government doesn’t receive by granting deductions to private landlords to fund investment properties is less than it would cost them to fund public housing if that private landlord did not invest otherwise. This allows governments to redirect funds into other areas such as essential infrastructure for the community.
• Self-funded retirees. As with public housing, an aging population suggests that in the future the pressure on the aged pension system will increase and it’s expected that the government probably won’t be able to afford it. Negatively gearing also encourages investment to allow those who wish to provide for their own future a tax subsidised method of doing so.

One of the main points surrounding negative gearing that is so often ignored by the media is that it does not just apply to residential property – it applies to investments in general. If the ability to write off losses from investment against personal income doesn’t just exist for residential investment property, but it also exists for share investments and other investments also, why is residential property being singled out? Here are a few reasons:

It’s inflating the housing market. To counter this argument, the first thing one must realise is that there isn’t just one big housing market. There isn’t even a Sydney housing market…or a Melbourne housing market. There are markets within markets within markets and unfortunately, the media likes to sensationalise property booms and busts as though they apply to every single postcode in Australia at the same time. A prominent Sunday night current affairs program last year ran a segment on the imminent collapse of “Australia’s housing market”. Yet the mining town they chose as a case study has been absolutely decimated in the past few years whilst Sydney has enjoyed a phenomenal bull run during the exact same period of time. How would this be possible if there is simply ‘a property market’? If markets were driven by negative gearing, wouldn’t that mining town’s property prices have been supported by the tax losses those investors were ‘enjoying’? It wasn’t and it isn’t – demand dried up as the mining boom slowed resulting in job losses, a drop in rental and purchasing demand and thus, a dramatic price fall.

As with any market, price is simply driven by supply and demand. The reasons for that supply and demand vary from market to market and aside from a few uneducated property speculators, the majority of investors do not invest in residential property to save tax.

Furthermore and as discussed already, only approximately 27% of Australia’s total properties are held by private landlords. Property prices are underpinned and driven by owner-occupiers whose emotional buying creates the demand for the dwelling. Of course, cheap credit and favourable economic conditions resulting in higher disposable incomes give buyers the ability to pay more, but overall the 70% of the market who are not receiving any tax advantages are still the major player in the supply/demand ratio.

It’s pricing first home owners out of the market. Once again, which market? When this is mentioned in various mediums, the ‘Sydney market’ is always referenced. However, there are capital cities all over the country where right now you can buy three or four bedroom homes less than a thirty minute drive from the city for $400,000 – $500,000. In 2017, these prices are not beyond the reach of first home buyers and once again demonstrates that you cannot simply pick a single booming market as the basis upon which to argue that tax policy is inflating house prices.

If first home buyers are unable to buy in these markets then it is a function of their inability to save a deposit, not necessarily the price that they are paying. There are markets all over the country where house prices experience little above inflationary growth each year and are well within the affordability constraints of your average first home buyer.

It’s helping the rich get richer. Now, I’m not going to enter into a debate about what is rich and what is not, but suffice to say that I know for a fact that the majority of people I have assisted with property investing are not rich. They are every day, hard-working people on average incomes who are trying to invest to improve their financial position over time. Once again, people do not invest to make a loss (which is what negative gearing is) – they invest to make money over the long term. If a person makes money, in time they will be taxed! The taxpayer is simply given a short term incentive (by assisting their cash flow loss) to enable them to hold the property until which time it does actually produce positive income and capital gain. It’s really that simple.

For those people who are complaining that negative gearing is simply “tax breaks for the rich”, firstly, it’s an extremely short term view and those people clearly have no understanding of gearing or investment in the first place so they are the last people who should be passing judgement on tax policy. Secondly, those exact same people are the one who will be hardest hit in later years when those greedy “negative gearers” will become reliant on the pension (as they were forced out of being able to self fund their retirement twenty years ago) and there will be a many more people taking from the same pool of money meaning everyone gets less.

Unfortunately, the average person does not seem to understand that whether it’s a single person, a business, a family or a government, budget planning is identical and there is only so much money to go around. If more people are forced into reliance on the system in the future for perceived short term gains now, everyone on the pension will end up with less

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So what are some things to think about in the face of changes to negative gearing that may not have crossed your mind?

At some point, negatively geared properties become positively geared and the government taxes the profit. When do we ever hear the statistics on how many once negatively geared properties are now positively geared and the government is now able to actually tax the income? You don’t, because it doesn’t support the position of those who wish to abolish it. Yes, this may take a few years but such a short term view seems to be the underlying position of governments all over the world in this day and age and one of the reasons why I believe politics should not be permitted as a career but simply a temporary vocation – but that is a whole other debate. The removal of negative gearing will result in a loss of the nursery ground in which property investors start to build their future wealth and therefore, a loss of their future taxable gains.

Most property investors will hold an investment property for twenty to thirty years but only negatively gear that property for the first five to six years. This means that the majority of the time that the investor holds that property, they are actually paying money back to the government in tax.

Stamp duty and other revenues will be affected. If we assume that the removal of negative gearing will result in a loss demand for investors, then there is a potential loss of stamp duty and other revenues. Every time a property changes hands, the state government charges stamp duty (just have a quick google on NSW stamp duty revenue increases since 2013!) and many other associated revenues are created.

Not only will less investors buy existing stock, but existing investors will possibly hold onto properties they would otherwise be thinking of selling to ensure they are retaining grandfathering provisions of any changes to tax policy. This is not to say that the offset is equal, but the fabric of the tax system is intertwined with many different policies and revenue streams that work like an ecosystem. If you change one, others will be affected. It’s an extremely complicated issue and not the linear arrangement that many main stream media outlets will have you believe.

A potential opposite effect. In a time where GDP is faltering and the outlook for the entire world’s economic situation is less than stellar, tinkering with an industry that is contributing its fair share towards our country’s economic growth at the end of a mining boom is probably not the greatest idea. It appears that the major parties are simply testing the public’s reaction to a few ideas such on how they can bolster the coffers and once again, negative gearing is put in the spotlight.

If demand does soften, the flow on effect from countless other sub-industries that rely on the housing market to support their business will also be affected. Although direct residential investment has historically made up about 5% of GDP, associated housing services approximate 12-13% giving a total of 17-18% of GDP that might be affected! This is not a small number! By intentionally limiting the tax deductibility in one sector of the investment market in an attempt to increase tax revenue, there is a very big chance it will indeed have the opposite effect.

The reality is that I could continue to write about negative gearing – the pros, cons and everything in between – for pages and pages. At this point in time however, it remains a fundamental part of our tax system and no one linear change in isolation can rectify the micro and macroeconomic issues at hand. A complete overhaul of the system is needed and until that happens, it would be a flawed and extremely risky position for any government to not only change one aspect of the tax system in isolation, but given that it applies to investments other than residential property, tinkering with a policy within a policy.

Until then, continue to invest with legislative risk and your gearing position in mind but always be aware that the fundamentals of property investment will still apply. We are investing in the second most important category in Maslow’s Hierarchy of human needs and whatever happens, property will always be in demand in some form or another. Take a long term view, don’t make broad and rash decisions, consult with an appropriate professional and consider your personal risk profile before making any investment decisions.

 

Good write up @Andrew Hancock. I think a major point that is often overlooked in this debate is that is if negative gearing was abolished for residential property, the benefits to investors are not lost, they are simply deferred. The losses are accumulated over the life of the investment. At sale, the accumulated losses are deducted from the capital gain for the property. The investor obtains roughly the same benefit, it's just a matter of timing. Do we want extra money flowing into the economy now or in the future?

The worst proposal I have seen is to not allow losses from a rental property to be offset against personal income but still allow the loss to be offset against other investment income such as dividends from shares. This would be a huge benefit to those with more mature and diversified portfolios and much higher incomes. This is certainly not mum and dad investors benefiting. That such a policy would get widespread support is ridiculous.

Living in Perth and watching prices collapse, it is hard to see how negative gearing has much impact on prices at all.

 

Is it not possible that "mum and dad" investors invest in property instead of shares because of this rather than the other way around?
If it was switched around, "mum and dad" investors could well invest in shares to offset their personal income.

 

There's not been any clear indication on what the finer points would look like but I'd suggest if it does get some traction..(which I don't think it will) Capital loss/profit will be calculated separately from trading loss/profit ie you wont bee offsetting accumulated losses against capital gains upon the sale.... But your point still stands as I expect that any trading loss will be offset against future trading profit. So it's just delaying the tax 'benefit' .

I've paid close to $40,000 in stamp duty in the past 13 months...just watch the states cry poor if the gov play with the rules...


Oh and watch other asset classes start moving higher when the rumor mill really starts getting momentum.

 

The government would be way out in front if they made you carry the loss. There is the time-cost of money to think about as well as how the 50% Capital Gains discount interacts.

Think about how depreciation works, you get to claim the full cost as you go on the understanding that you are reducing your cost base when you sell (creating a bigger gain). But then when you sell , you are getting a 50% discount on the increased gain it causes anyway.

Alternatively as someone else said they may only allow you to offset it with other investment income.

 

@Perthguy cheers! Regarding losses against future gains - absolutely! It's my understanding though that losses could be offset against future cash flow profits, not necessarily capital gains (much like a trust). I'm not an accountant however so some clarification from someone more qualified in this area would be great.

@Anthony Brew It's my belief Mum and Dad invest in property rather than shares because they feel like they understand property investment, having usually purchased one or two PPoRs prior to commencing property investment. This is why so many mistakes are made by those starting out because they think buying an IP and PPoR is the same thing. I'm not convinced share investment would be made to the same levels (volume of dollars invested) as it's not well understood by Mum and Dad as an investment class and therefore the risk profiling would be totally different.

Good debate!

 

Well, mum and dad can a already Negatively Gear shares, so that won't change. Why don't they already? It's not particularly financially attractive to buy loss making shares. I can't see how this will change.

 

Anthony, how many people do you know who deliberately invest in anything "in order to offset their personal income" ? Maybe very high-income earners, but not your typical mums and dads. The majority of income earners earn low or medium incomes. I would think that offsetting personal income is not as important to them as it would be to those on much higher incomes.

The people who want to remove NG tell us that we use it for the sole purpose of reducing our tax payable. If I want to reduce my tax payable each year, I can salary sacrifice into my Superannuation. I can show you some financially illiterate people (state govt employees) who salary sacrifice their monthly household bills for no other reason than to "reduce the amount of tax they pay". The ones I know personally have no thought about saving up for retirement. "That's what the pension is for", they tell me.

Salary sacrificing is so much easier than being a landlord. No, Mum and Dad investors are primarily trying to get ahead and support themselves in retirement.

 

If it wasnt for NG my first IP wouldnt have been bought
The loan was that tight
Yet now only 1 year on I will recieve no NG next financial year
(Due to a rise in rent and Depreciation it will be positively geared)
So TRUE, short term help and now i must pay tax

 

Our first IP was bought in 1992 (nearly 25 years ago). Yield is now 19% of the original purchase price. So, it is truly cashflow positive. The Offset attached to its loan is fully chocked. So, it is even more cashflow positive.

We had to buy another NG IP to reduce how much tax we were being charged .

 

Coming from Perth - with property prices effectively stagnating for 10 years - the attraction of negative gearing is not that high on clients priorities.

If you lose 3% a year after tax for 10 years you have lost 30% cash plus the opportunity cost.

I saw a lot of geniuses pre 2007 who are now out of the property market altogether.

If you can only afford with the tax benefits you cannot afford it.

 

The problem isn't negative gearing per se. The problem is the combination of negative gearing and capital gains tax concessions; the two have worked in concert to make property investment unusually attractive, and easier than it probably should be. When too may investors can enter the market, yes gains can go through a long phase of strong growth, but this is offset by three major problems:

1. when housing investment becomes too easy, where all you need to do is buy just about anything and hold to make a profit, this growth attracts a lot of inexperienced investors who will often make unknowingly risky decisions - taking on too much debt, leveraging everything they own, having no idea as to market fundamentals, assuming growth on past performance alone. It is these noob investors who crash housing markets - they buy in drove, close to the top, indiscriminately and without any real foresight. Many have no plan beyond aquiring as many assets as they can as fast as possible. Many start to see property as an easy, lazy profit train.

These types of investors - though they generate temporary demand and push up growth - are bad news for more experienced investors. They make it harder to enjoy a stable investment journey, certainly long term.

Imagine the housing market is a bread factory. The bread - representing investment properties - are an important staple of society. If you start adding in more and more factory workers, your production will increase for a while, and hey, everyone needs bread! Everyone's making money! But if you have too many cooks in there, everyone will start stepping on each other's toes. And if your production increases faster than demand for bread, you'll end up with piles of it stacking up all over the place, going moldy, at risk of becoming worthless or at best reducing bread prices. Long term, overproduction doesn't help anyone.

And yes, I know houses aren't bread, but investment markets work better where investors make good decisions, assess risk, dedicate themselves to investment as a craft. They work best where rental income, rather than capital gains, is the primary source of income - negative gearing used to be a stop gap, a temporary measure to help get people started. It's become an aberration now, because it encourages too many new investors to snaffle up loss-making assets, financed by too much debt - risking the incomes of everyone else. What happens when prices stop rising? What happens when we see even the smallest correction? Many of these inexperienced investors are in over their heads - they're not like us. They won't hold. And everyone could suffer for it.

2. when asset bubbles form, other avenues of investment are neglected. When everyone's investing all their eggs in the property basket, shares and business investment are sidelined. Share ownership in Australia has grown very slowly over the past two decades - unusually so. The ASX has spun its wheels. This has a knock-on effect on business success... which brings me to -

3. when property becomes too expensive, the whole engine starts to destabilise. Buyers can't buy in, people stop spending so business, tourism, entertainment, retail - these industries suffer, causing more economic stagnation. Incomes fall, and this risks further price growth.

The current situation has caused a bubble. The number of new investors has hovered at around 50% of the market for years, reaching close to 60% at one stage. Extreme price movements have created risky debts and over-construction, so that we now have a situation of oversupply emerging - risking not just those new-comer investors but everyone. Making investment too easy is not is anyone's interests. It should be hard work. It should take effort. We need to find a better balance, discouraging the inexperienced who will struggle to afford any changes to any market variables, from jumping on what they see as little more than a bandwagon. If too many people try to ride a wagon at once, it will eventually stop moving, and the wheels will fall off.

 

I saw this in my area in Perth. Inexperienced investor first time developers buying at the top of the market thinking they could make a quick dollar developing apartments. It did cause a price bubble which collapsed. By my analysis these development sites dropped around 30% from peak to now. I know some lost money on their deals. Not good. Interestingly though the CGT and NG laws had nothing to do with this price bubble and collapse. These were development sites, so CGT does not apply. I wonder how many first time developers were aware of this when buying?

Do you have a source for this claim that share ownership in Australia has grown very slowly over the past two decades? I would be very surprised if that is true. Primarily super funds invest in Australian shares and super is growing exponentially. Or are you talking about private, direct share ownership? Even that is not a good metric because when I diversify my investment portfolio, I will be doing so by buying ETFs and LICs. So I will be indirectly owning Australian shares.

Have you thought about the relationship between super and residential investment property? My super is predominantly invested in Australian shares with International shares being a close second. This is not a self managed super fund.

When I look at where to invest outside of super, my first though is if I buy Australian shares I will be overexposed to fluctuations in the stockmarket and have all my eggs in one basket "Australian shares". I buy resi investment property to diversify my investment portfolio, which include investments in super and outside of super. I wonder how many other property investors have their super tied up in Australian shares so buy property to diversify?

 

Yes I would have thought share ownership would have grown significantly with the ability to quickly set up online accounts such as etrade, Commsec and NABtrade etc. Much easier for the general investing public and considerably cheaper than using a full service broker and spending $100+ on brokerage fees per trade.

The only caveat I would make would be that in 2007 when everyone was buying anything, especially mining services companies and mining speckies. Nothing more than glorified gambling, many people were burnt in 2008 and I would guess some haven't returned to the market?

 

I don't know. I am trying to find facts and figures because I am very interested in this topic.

The reality is that Australia has one of the highest rates of direct share ownership in the world although the rate has fallen since the prevalence of superannuation.

This is my working theory about Australia's obsession with residential property:

- during GFC we saw Australians close to retirement lose significant value of their superannuation. I have heard reports of 30% and 50% in worse cases.
- Australians suddenly realised that a significant proportion of their wealth was tied up in the "risky" stockmarket
- Looking to diversify, investors bought more property than every before. This has been made easier by easy credit, low interest rates, 50% CGT concessions and NG.

It makes sense to me. I don't think easy credit, low interest rates, 50% CGT concessions and NG drove Australians to residential property. I think it was GFC and the fact that super is mostly Australian shares.

 

Sure thing, but this ASX study doesn't include share ownership in superannuation - though that's for a good reason. Super usually isn't included because it's a very different form of investment designed for retirement saving, not general wealth building and investment to increase personal income - you can't really directly compare it to say investing in property.

Share ownership has dropped off significantly in ten years, as property ownership has grown. Previously share ownership was up around 50% and at 2004 was at a high of almost 55%. Since then, share ownership has fallen to 36%. This was a fall from 38% when the last iteration of the study was conducted in 2012.

Share ownership is popular with retirees and near retirees, but in recent years the largest group has become young people aged under 35. It is likely many of this group are using share ownership as an alternative to property, or as a vehicle to save for deposits. Ownership in overseas shares is rising too, as investors diversify away from Australia.

As share ownership has dropped, property investment has increased in popularity (by about the same degree - property investors have made up around 50% or more of the market for around 5 years, where share ownership has dropped into the 30%s - which is where property investment sat prior to the 1990s).

That's a lot of new property investors in the market, and the lack of share owners investing in Australian business might also help explain some of the stall in income and economic growth. It's possible the ASX is being neglected... if the market does correct and property investment loses some of its recent popularity, we may see a swing back to share ownership in the longer term.

 

Well, with super funds able to invest in residential property...

Why do you think after GFC, Australian's turned to property instead of shares? If my super company is investing my super in shares, why would I buy more shares?

I would say that direct share ownership has dropped off as the value of superannuation has grown. Super is now worth $2.2 trillion (1). The total resi property market is worth $6.2 trillion (2). However, we know that on average around 70% of properties are owner occupied, so the value of residential investment property would be around $1.86 trillion. This is less than the value of super. That is a very important statistic to be aware of in this discussion.

I would agree but I think it is the superannuation factor driving people to invest in property. Besides the family home, the next biggest wealth a family will own is superannuation. With superannuation predominantly invested in shares (Australian and International), I really do think that people are buying property to diversify. If your household wealth (aside from the family home) is predominantly invested in shares, why would families buy more shares? It just doesn't make sense to me.

If you want to understand share investment vs property investment, I really don't think you can do this without understanding the impact of superannuation and the GFC on investor psychology.

(1) Super statistics - ASFA
(2) 6416.0 - Residential Property Price Indexes: Eight Capital Cities, Sep 2016

 

Well... maybe. With these sorts of trends it's certainly hard and it's never a good idea to give too much stock to correlations. People may be seeking to diversify. But other countries also have retirement investment funds as the norm, and their existence hasn't really turned people off shares. One thing that could have put shares on the nose is the fact the ASX hasn't really performed well in a decade. In fact it's still below its pre-GFC peak (though you could argue it's close to fair value nonetheless). It hasn't been performing at a rate that's attracted a lot of attention like property has, so to speak. I think it's more an issue of so-so returns keeping people away.

 

I think another reason why there are so many new property investors in the past decade would be the easy access to information via the Net. If I want to buy property, I go online and look at maps, look at real estate websites, read a few books, get a ton of banking and mortgage information, view this forum, etc etc.

Before that we had to make some phone calls and travel around in person to find properties. It was hard work, much more difficult than it is today. You had to know someone who could teach you and point you in the right direction............