FEATURE

Negative gearing: separating fact from fiction by David Montani, CTA, Director, Nexia Perth

Abstract: Negative gearing is commonly understood among the wider public to mean a concession in the tax law that allows a taxpayer to deduct a loss made on a geared residential rental property against other income, thereby reducing the taxpayer’s tax exposure. However, as practitioners, we know that this understanding is misconceived. It also misses the broader policy context within which negative gearing exists. The poor quality of the discourse on negative gearing in the lead up to last year’s election was disappointing. It was apparent that it had been an unexamined subject for so long that myths had solidified into truths in the minds of both defenders and detractors. While the re-election of the government means there will be no changes to negative gearing for now, it is clear that the subject is not going to go away. This article examines the various claims made about one of the most controversial tax policies in ’s history, and in doing so, reveals an opportunity for a value-added client service.

Introduction However, this fails to take account of the tenant demand, resulting in rents rising One of the most frequently made fact that the bulk of negatively geared significantly. It is also claimed that the statements about negative gearing is rental losses are made up of rise was exacerbated by new that it’s a legislated tax concession. payments to Australian banks. The increasing rents to cover the additional tax However, there is no specific law enabling banks (and their Australian shareholders) burden (even though it was only a timing a deduction for a rental loss. Rather, the pay income tax straight back to the difference). ability to deduct rental property expenses government. Accordingly, this “lost tax The changes were reversed from 1 July arises from the same 25 words in s 8-1 revenue” criticism of negative gearing is 1987. Over that period, these were the of the Income Tax Assessment Act 1997 unfounded, or at least wildly exaggerated. inflation-adjusted movements in residential rents in our five largest cities:3 (Cth) that allow most deductions. So, Reduction in house prices although some might think they are availing A rather fervent claim made is that Sydney  Up themselves of a specific concession restricting the deductibility of negative when claiming a deduction for a rental Perth  Up gearing losses would cause a reduction in loss, they in fact do no such thing. Melbourne  Even the demand for housing, with a resulting Rather, the rental income and expenses significant reduction in house prices. The Brisbane  Down are simply combined with a taxpayer’s possible impact from different models Adelaide  Down other assessable income and allowable of restricting negative gearing has been deductions. This is why speaking in terms studied by various bodies, and the Rents rose only in Perth and Sydney, of “abolishing” the negative gearing “tax conclusion is a modest, one-off, fall of and in fact went down in Brisbane and concession” is meaningless — there’s 1–2%.2 Accordingly, the evidence does Adelaide. The evidence is that these nothing to abolish. Rather, what that really not support this claim. changes reflected local factors, such as means is the opposite — to discriminate differing points in the normal vacancy against the asset class that is residential Increase in rents cycle, which explains why there were also property, by carving out an exception to Another claim is that restricting negative falls. The other point to make is that a new the normal rules. gearing will cause a significant increase in subject to the quarantining rules Interestingly, Australia and New Zealand residential rents. This is largely based on demanding a higher rent would hardly have are the only developed countries that don’t the short-lived quarantining of negatively been able to compete for tenants against interfere with the deductibility of negative geared rental losses from 1985 to 1987. all the existing investors. So, the evidence gearing losses for residential property. For properties acquired after 17 July does not support the claim that restricting All others either quarantine or restrict it in 1985, the losses were quarantined and negative gearing will increase rents. some way, and the UK, Netherlands and carried forward, and could only be Japan in fact outright deny any deduction.1 deducted against future rental profits and Even playing field capital gains. All existing properties were It has been argued that it is appropriate not Lost tax revenue grandfathered from the changes. The to interfere with negative gearing because It has been claimed that the government argument is that the quarantining caused that ensures an “even playing field” across loses billions of dollars in tax revenue investors to leave the market, reducing all asset classes. You can borrow to invest each year from the rental losses deducted. the supply of rental properties relative to in other asset classes such as shares,

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business and commercial property, and are analysed more comprehensively, the To state the obvious, of course we all like allowed a deduction for your interest and statistics show that the claim is misleading. to hold assets that grow in value. But the other expenses. The argument follows that point being made by promulgators of discriminating against residential property Tax minimisation strategy this criticism is that this kind of growth would be unfair. Negative gearing is sometimes described (ie speculative) in this asset class as a tax minimisation strategy. A deductible However, the reality is that different factors (ie residential property) does not add outgoing of $100 incurred by someone on come into play with different asset classes any productive value to the economy, the top tax rate might reduce their tax bill and different kinds of owners such that and comes with social costs that cannot by $49, but that still leaves them $51 out of tax policy frequently interferes with an be ignored. Their purpose in arguing for pocket. If that’s all there was to it, negative otherwise even playing field. There are restricting negative gearing is to curb gearing is hardly a smart strategy. When undesirable economic behaviour that many examples, but notable ones include assessing a potential , taxation results in benefit for some, but at a cost the legislated exemption from capital gains outcomes should always be a secondary to others. tax (CGT) for the family home, and the consideration behind the expected small business relief CGT concessions. commercial return. Encourages housing supply If one subscribes to the “even playing field” The real purpose of borrowing to leverage An often-repeated defence of negative argument in support of negative gearing, gearing is that it encourages investment into a bigger investment footprint is to that is, that there should be consistent in rental properties, thus increasing the amplify capital growth, advancing the tax treatment across all asset and owner supply of housing, and therefore improving investor’s net wealth over time. While rental classes, with no account taken of any housing affordability. However, 93% losses are incurred in the earlier years, the factors unique to any particular class, then of property lending is for purchasing investor’s intent typically is for the growth one would argue that the family home established houses,7 which doesn’t add in the property’s value to exceed the should be subject to CGT just like other to the supply of housing. Accordingly, this losses. However, as we will see later, that’s assets, and that there should be no small defence is a fallacy. The main criticism of actually an oversimplification, and therein business CGT relief concessions. negative gearing noted above is therefore lies a service offering for clients. Just as there are factors particular to, for left to stand. Remember that the criticism example, the family home that warrant is not of negative gearing on its own, but a departure from the normal rules, in combination with the 50% discount on there might well be factors particular capital gains. to residential property that give similar Financial advancement cause, but which do not trouble other The reality is that asset classes. This is canvassed further Another claim is that negative gearing is below. This kind of situation is precisely all except one of the only way for some people to get ahead why, when warranted, tax policy does financially. However, only about 10% of discriminate. Accordingly, the “even playing the claims about taxpayers have a negatively geared rental 8 field” defence of negative gearing does not property, so we’re only talking about a withstand scrutiny. negative gearing … small minority. In any event, this prompts a pertinent Middle/low-income users do not stand up question: how many people actually know Two-thirds of people claiming a negatively to scrutiny. whether or not their negatively geared geared rental loss have a taxable income property has advanced their wealth? below $80,000.4 The claim is thus made The accumulating rental loss diminishes that negative gearing is used mostly by the investor’s wealth. If the property middle- and low-income people, rather becomes positively geared, that diminution than by wealthy people. However, the Broader policy context starts to reverse. Few properties become $80,000 figure is after claiming the negative The above wealth creation strategy from positively geared, so the goal for most gearing loss. Measuring this statistic by negative gearing might make sense from an investors is for the on eventual the pre-loss taxable income would be individual perspective, but is actually the sale to exceed the accumulated rental a better reflection of reality. Also, most very basis of the main criticism of negative loss. However, this approach is not quite middle/low-income investors have only gearing. The claim is that, in combination correct. The reason is that rental losses one property, whereas the dollar amount with the 50% discount on capital gains, are deductible in full, whereas a capital of negative gearing losses claimed is negative gearing artificially inflates demand gain on sale of a property held for at least skewed towards people in high-income for houses (as ), fuelling 12 months is reduced by the 50% discount occupations, who tend to have multiple speculative growth in house prices.5 This (except for companies). properties.4 This claim also takes no reduces housing affordability, which has This asymmetrical tax treatment means account of negatively geared properties fallen since the 1980s to problematic the capital gain required to break even is held in trusts, companies, and SMSFs, levels. The ratio today of household — not simply equal to the accumulated rental which are vehicles not typically used by mostly comprising the home mortgage — loss. An investor who assumes it is will middle/low-income people. In summary, to disposable income is significantly higher likely get it wrong when assessing whether this claim is based on an incomplete than it was thirty years ago,6 leading to a or not an investment has advanced their statistic, taken at face value. When number of wider social problems. wealth, or by how much.

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In order to know whether a negatively capital gains — the resulting contribution the property, revealing whether or not it geared property has advanced a person’s to unproductive speculative growth in has advanced their wealth at that point in wealth, these three questions must be house prices, and thus reduced housing time. As noted above, the asymmetrical answered: affordability. It might be expected that if tax treatment between rental losses and (1) What is the accumulated after-tax there is an issue that requires attention, it the capital gain means the capital gain rental loss? would be particular to residential property, required to break even is not simply equal and of no bother to other asset classes. (2) What is the required sale price to the accumulated rental loss. That is the case here. Not only that, but (factoring in selling costs) that will The example below illustrates a process for it impacts all participants in the asset produce an after-tax capital gain equal calculating the break-even sale price for a class (and aspiring participants), not just to the answer to question 1.? This is the client’s negatively geared rental property. investors. property’s “break-even” sale price. Having become aware of new facts, (3) What is the property’s estimated Example: Break-even sale price for a exposed claims as myths, and current market value? rental property acknowledged that tax policy does Property details9 The answers to the first two questions discriminate when warranted, we as can be worked out as at any point in time, practitioners are better placed to engage $ and they are continually changing. Only in the discourse on whether there is a Original cost base 445,000 10 when an investor knows the break-even case for the policy settings for negative Borrowing costs 5,000 sale price can they then compare it to the gearing to be changed or left as they are. property’s current value, and know whether Total 450,000 Of course, individual tax policy settings or not it has advanced their wealth. Funded by: do not operate in a vacuum — each is like It seems that virtually nobody with a a piece in a jigsaw puzzle. In the jigsaw Owner’s contribution 90,000 negatively geared property monitors puzzle of Australia’s tax system, it would Bank debt 360,000 11 the answers to all three questions, with be fair to say that the pieces do not fit Total 450,000 perhaps only the third one receiving any together well. Negative gearing is but one attention. If people generally don’t actually of those pieces, and genuine reform can The accumulated after-tax rental loss for know whether their negatively geared only be achieved when all of the pieces — this property is summarised in Table 2. property has advanced their wealth, this income tax, , GST, state The break-even sale price for this property claim is meaningless. etc — are reformed to fit together is that which will produce an after-tax more neatly. Summary capital gain equal to the accumulated A summary of the various arguments for Calculating break-even sale after-tax rental loss of $47,580. To and against the current policy settings is price determine that, work out the property’s set out in Table 1. Aside from being better equipped to current cost base, and nominate the The reality is that all except one of the engage on the subject, another positive anticipated tax rate that would apply to the claims about negative gearing — both for outcome from the above discussion is capital gain that would arise if sold now, and against — do not stand up to scrutiny. that it reveals an opportunity for a service as follows: This has caused much distraction and offering to clients. Practitioners can offer Capital gain’s elements misinformation in the discourse on the to clients to work out the break-even sale Current cost base $405,000 13 subject. The one claim about negative price for their negatively geared rental 12 gearing that has some validity is — in property. The client can then compare Anticipated tax rate 0.39 conjunction with the 50% discount on to the estimated current market value of CGT discount 50%

Table 1

Arguments for leaving negative Valid? Arguments for restricting negative Valid? gearing as is gearing Restricting will significantly reduce house No Remove a “tax concession” No values Restricting will significantly increase rents No Redress “lost” tax revenue No Even playing field No Fuels unproductive, speculative growth in Yes, but in combination house prices; reduces housing affordability with the 50% discount on capital gains Used by low/middle-income people No Tax reduction strategy No Increases housing supply No Only way for some to get ahead financially No

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Table 2: Accumulated after-tax rental loss

2016-17 2015-16 2014-15 2013-14 2012-13 Total (estimated) $ $ $ $ $ $ Rental income14 22,000 22,000 21,000 21,000 20,000 Total deductions14,15 (38,000) (37,000) (36,000) (36,000) (37,000) Net loss per tax return (16,000) (15,000) (15,000) (15,000) (17,000) (78,000) Marginal tax rate12 0.39 0.39 0.39 0.39 0.39 Tax saving 6,240 5,850 5,850 5,850 6,630 30,420 After-tax loss (9,760) (9,150) (9,150) (9,150) (10,370) (47,58 0)

We can now work out the required pre-tax Net cash position after sale $ 6 International Monetary Fund, Global housing watch, October 2016. capital gain to achieve an after-tax capital Sale proceeds 464,106 18 gain of $47,580, as follows: 7 Australian Bureau of Statistics, Lending finance, CGT per above (11,526) 2013. Required pre-tax capital gain 8 Reserve Bank of Australia, Submission to the Inquiry Repay bank debt (360,000) into home ownership, House of Representatives $ Net cash 92,580 Standing Committee on Economics, June 2015. Capital gain 59,106 16 9 The property is taken to be wholly input-taxed. The test check confirms that the net cash Therefore, no GST liabilities arise, and no input tax Capital gains tax (11,526)17 outlay and inflow are equal. The above credits are available. After-tax capital gain 47,580 would provide useful information for a 10 Includes all incidental costs, depreciable items. 11 Interest-only. Now we determine the break-even sale client in assessing the performance of their 12 For this example, the 37c rate plus 2c Medicare levy price by adding the required pre-tax capital rental property investment. This process is used. This assumes that the pre- and post-rental gain (ie capital growth) to the current cost can also be applied to any other kind of loss taxable incomes are both within the $87,000 – base as follows: negatively geared investment. $180,000 tax rate band. If the pre/post-taxable incomes fall into different tax rate bands, you will need to calculate a proportionally blended tax rate. $ Conclusion 13 $ Cost base 405,000 In undertaking an evidence-based analysis, Original cost 445,000 Capital growth required 59,106 many claims made by both defenders Five years’ depreciation and capital Break-even sale price 464,106 18 and detractors of negative gearing are works deductions (40,000) revealed as unsupported, or simply myths. Current cost base (includes depreciable We have determined that in order to This enables us to focus on what actually items) 405,000 break even on this property, the client matters when engaging in the discourse The cost base will change constantly due to the will need to achieve a sale price, net of on whether or not any changes to current capital works (post-May 1997 properties) deduction. selling costs, of $464,106. This can now policy settings are warranted. Our analysis For simplicity, it is assumed the market value of be compared to the property’s estimated depreciable items is equal to their tax written down also reveals a service offering practitioners value. current market value to determine whether can provide to clients — working out the 14 Taken directly from the rental schedule in the client’s or not the investment so far has advanced break-even sale price for a negatively tax returns. the client’s wealth. It is worth noting that, geared investment. That’s a rather 15 Deductions each year include a total of $8,000 in this example, the asymmetrical tax for depreciation and capital works, and $1,000 worthwhile thing for a client to know. treatment is why only a $59,106 pre-tax borrowing costs write-off. capital gain is required to break even, 16 $47,580/[1 – (50% × 0.39)] = $59,106. No account has David Montani, CTA been taken of the time value of money. despite a higher accumulated pre-tax Tax Director 17 Capital gain of $59,106, less 50% discount, × 39% = rental loss of $78,000. Nexia Perth $11,526. As a test check, here is a summary of the 18 Net of all selling costs. client’s net cash outlay over the course References 19 If the break-even sale price were being calculated before the borrowing costs have been fully deducted, of the investment, and what the net cash 1 J O’Donnell, Quarantining interest deductions for negatively geared rental property investments, 2005. will need to incorporate the remainder deduction into position would be after selling the property Updated for policy change in Japan. determining the after-tax accumulated rental loss. for the break-even sale price. 2 For example, see The Grattan Institute, Negative 20 The depreciation, capital works and borrowing cost deductions totalling $9,000 per year are added 19 gearing and capital gains tax reform, April 2016. Reconcile cash position back, as these are not cash outlays. They are part of 3 S Eslake, Submission to Senate Economics the original costs of the property, and have already Net cash outlay $ $ Committee affordable housing inquiry, 2014. been accounted for in the owner’s $90,000 equity Owner’s contribution 90,000 4 ATO, Taxation statistics, 2013-14. contribution. Total after-tax rental loss 47,580 5 Reserve Bank of Australia, Submission to the Inquiry 21 It is interesting to note that the tax saving from the into home ownership, House of Representatives above permissible write-offs significantly reduces Non-cash deductions20 (45,000) 2,580 21 Standing Committee on Economics, June 2015. the investor’s net cash outlay, outside of the equity D Murray, et al, Financial system enquiry, November contribution. In this example, it amounts to less than Total 92,580 2014. $10 per week (ie $2,580/5 years/52 weeks).

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