In light of the recent revelation that Treasury suppressed documents that showed Labor’s changes to negative gearing would have only a “modest” impact on the housing market — despite the government’s claims to the contrary — Crikey has decided to release this item from the vault. In this piece, originally published on February 18, 2016, economist Jason Murphy explains exactly what negative gearing is, and whether or not it’s a fair model.
Labor wants to change our negative gearing regulations, the Coalition is not so sure. You sure can read a lot about negative gearing without anyone clearly explaining what it is. Let’s fix that.
What is it?
Negative gearing is about having two sources of income: a job and a rental property. But the rental property creates a loss, because the rent doesn’t cover the mortgage. You use the loss to reduce your taxable income.
Example: Salary of $60,000, loss of $10,000 on the rental property; taxable income $50,000.
This would save tax of 32.5% on $10,000 of income, or $3250 less the property owner would have to give to the government.
Negative gearing reduces your tax. It works the same way as giving to charity or buying a uniform for work. You simply deduct your annual property rental loss from your total income.
It is worth repeating: negative gearing doesn’t create free money. It actually requires you to make a loss on your rental property. In the example above, the investor lost $10,000 and saved just $3250 in the tax system.
The biggest discount is for the top tax bracket, members of which pay 49 cents in the dollar, including the Medicare levy and temporary budget repair levy. They would save tax of $4900 on every $10,000 of rental loss but they still lose $5100 after tax. Of course, after enough rental losses they won’t even be in the top tax bracket any more and the benefit shrinks.
If you don’t pay much tax, negative gearing is a bad idea. Nobody should be depending on negative gearing to pay for electricity and tins of sardines.
Average people own investment properties — most people using negative gearing are teachers, etc, as we’ve heard — but they get only a small share of the advantages because of their lower tax rates.
Is it fair?
Housing doesn’t get special treatment. You can negatively gear other investments. You could borrow money at an interest rate of 4%, then put it in a term deposit at 3%. You’d make a loss there and can offset that against your tax. Nobody will complain.
This example is nice because it shows how weird negative gearing properties is. The only reason people do it is because they think the properties will go up in value by more than the annual loss. If you make a loss of $7000 a year after tax, you need the house to appreciate by $7000 per year.
You could try to negatively gear a small sole trader business, but nobody does — nobody expects a loss-making business to rise in value. Housing, clearly, is different.
Negative gearing was introduced by the Bob Hawke-Paul Keating government of the 1980s, amid a fight over rental prices. Now Labor is pledging to mostly undo the changes, which could reap the taxman around $1 billion to $5 billion a year.
What’s capital gains got to do with it?
No discussion of negative gearing can proceed without talking about the other big tax rule for investing: capital gains tax (CGT).
When you sell an asset, you don’t need to pay tax on the full capital gain. If you own a property for over 12 months, the capital gains tax discount is 50%. So if you make $100,000 profit, you pay tax on just $50,000.
(The 50% discount after 12 months applies to other assets too, like shares. This rule began in 1999. Before that, the tax was calculated on profits that were calculated after taking into account inflation.)
CGT discounts make speculative investing desirable. Without the CGT discount, profits on housing would be smaller, so fewer people would want to use negative gearing.
The two systems work together to increase demand for housing as an investment.
What would happen if we got rid of negative gearing?
If we got rid of negative gearing, some landlords would try to put up rents in order be positively geared. Others would try to sell their properties.
These two effects go in opposite directions. First, rents would increase. But then, if landlords started selling off properties, property prices might fall. That could cause rents to become cheaper.
This is why people fight so much about negative gearing. It is not clear if it is good for renters, and it is not clear if it is propping up the housing market.
Labor’s plan to restrict negative gearing to new properties should help increase demand for new homes, prices of new homes, and supply of new homes. It should shift the rental market towards that sector.
The overall effect on rents and property prices would be very interesting to observe. Confounding any estimate will be the fact that more renters would end up in shiny new flats, while the supply of big old homes as rental properties will probably dry up.
But even the election of a Labor government wouldn’t necessarily mean immediate implementation for these reforms. The property industry will fight tooth and nail, and delays are very likely. Keating himself flip-flopped under pressure on negative gearing — to expect smoother sailing now the property industry is even more powerful is very unlikely.
Oh Please! The Hawke-Keating Govt did NOT introduce negative gearing in the ’80s. It was introduced at least half a century earlier. Hawke & Keating wound it back because they knew it was a rort but then reversed their decision because of the alleged adverse impact on the cost of renting, something that has since been roundly disproved.
Jesus wept!
Thank you. Logged in to make exactly the same comment.
Also “landlords would try to put up rents“!? So the article is saying landlords are kind and giving individuals and aren’t currently pushing for the maximum the market will bear? What complete rubbish. The author must have missed econ 101. Rents are set by supply and demand, not ‘cost plus’. There would be no short term impact on supply or demand hence unlikely to be an impact on rents. And that is what you see in the data from the mid 80s when Hawke-Keating removes negative gearing. In the long term, houses are not going to disappear, the skew to new builds might increase supply (currently something like 95% of negative gearing is in respect existing houses rather than new builds) and the increase in net carrying cost of a property might mean less properties held back from the rental market. It is entirely possible that removing negative gearing and CGT discount will decrease rental costs over time.
I would have expected Crikey to correct the glaring errors in a two year old piece before republishing it.
The point of negative gearing is an assumption that the capital gain is more than the operating loss and also the opportunity cost (of investing elsewhere for a better return). If not then you are losing money whether offset against tax or not. Too many people who look at a negative gearing investment strategy forget about this. I think the Labor policy is a good idea in that it provides a benefit to create employment (building industry) and increase supply. It should be analysed seriously and without bias (good luck with that).
One element of negative gearing you don’t mention is the beautiful fiction of depreciation (fiction because while washing machines depreciate, building repairs can be claimed in full and most buildings don’t need to be replaced after 40 years). Depreciation is on a sliding scale, with the greatest allowance in the early years. No actual money passes hands (other than the original capital cost) but the allowance is a great addition to the write off of income tax so that a positively geared property can become negatively geared in a flash.
All good, but the bit that really needs to be emphasised is the impact of those combined tax breaks on the rate and degree of housing capital gain itself. A house is not just a house; it’s a house & (to an investor) tax break package, and that makes it inherently more attractive (especially in a low interest environment) as an investment proposition. This distorts demand and sale prices go up further (for everyone, of course) than they otherwise would, thus feeding back into the CGT rise/pay-off which is the key investment raison d’etre. And so the whole tidy little set-up is a self-perpetuating bubble machine: it’s a good investment because it capitally-gains quickly at reduced tax because lots of people compete to invest in it which pushes the prices up quickly making it a good investment because it capitally-gains quickly at reduced tax because it’s a good investment because it capitally-gains quickly at reduced tax because it’s a good investment that goes up and up and up and up…oh, until it just doesn’t anymore, because now the mining boom is over and, oh yeah, the cost of money is on the climb again at last, so there just ain’t enough mug Ponzi feeder dosh available to keep shovelling in at the bottom so the whole dishonest edifice keeps capitally-gaining, quickly and at reduced tax…
Why this emphasis matters is that removing these tax benefits, even partially, will see the reverse happening, same symbiotic self-perpetuation, but downwards, to…well, who knows? We will get a good decko at the real worth of housing in Oz for the first time in, say, two decades. That sixteenth storey 2 bed apartment in Strathfield you paid $1.2 million for last year? Well, you might just struggle to attract $700,000 at market, if all you’re now selling someone is a place to live, or rent out (instead of a place to live plus a mechanism for dodging income tax and/or CGT). There’s literally tens of thousands of these joints in the main cities newly built or nearing completion, made viable off-the-plan as much by the tax break component of that house & tax package product, as by its bricks-and-mortar utilitarian economic function. Throw in the recent flood of Chinese capital trying to get itself off the mainland, and we Asian White Trashies have become the witless inhabitants of a housing market that for all we know bears zero relationship to any sustainable supply-and-demand equilibrium.
Home to a sh*tload of ludicrously over-geared older mortgagees, a bunch of young, locked-out lifelong renters, and a relatively small and shrinking cohort of property-rich landlords who pay (relatively) bugger-all tax.
One thing is guaranteed, of course: this latter group – those who have benefitted most from this repulsive tax scam over the last 30 years – will benefit most from its imminent dismantling/implosion, too. Because they are the Australians with long-established housing equity, income excess/liquidity and first-in-queue access to credit (whatever the interest rates go up to). I suspect this blessed lot will wander about the joint, snapping up dirt-cheap property, in the harshly corrective housing market chaos likely to descend…
Yep, a hobby horse, and I am a windbag on it. Apologies. But I just do not reckon people fully grasp the magnitude of the disaster we have created.
Spot on dude, you nailed it. The baby boomer property moguls will be liking their lips.
Negative gearing has spawned an industry, with property spruikers selling the idea to people who are in the lower income bracket (definitely not with taxable income over $80,000).
In many cases the investment is in an apartment building. A rent guarantee (usually well in excess of market rent) for five years is provided as a sweetener.
Returns are calculated allowing for rent inflation, and capital gain. Expenses are normally understated.
Most of these investors will receive nothing on their investment, and will be much the poorer for having been persuaded to take up the investment.
The main beneficiaries are those who market the proposition, and the builders. Commission is very generous.
A handyman could reduce the maintenance costs, but his time should be factored into the costs.
I shudder to think of the situation of those who were persuaded to invest in apartments in buildings with flammable cladding.