Negative gearing (Australia)
Encyclopedia
Negative gearing
is a form of financial leverage
where an investor
borrows money to buy an asset
, but the income generated by that asset does not cover the interest
on the loan. The investor must fund the shortfall until the asset is sold, at which point a profit
is made if the capital gain
on the asset exceeds the accumulated loss.
The tax
treatment of interest expenses and future gain affects the investor's final return. Tax rules vary from country to country. Losses from negative-geared property investments are currently tax-deductible in Canada, Australia, and New Zealand, which are all countries in the Commonwealth of Nations
.
, negative gearing usually refers to borrowing for a residential investment (e.g. a house or unit) which is rented out. In most places rents are less than the interest on property value, and the investment thus results negative gearing if the investor borrows, for instance, 80% or 90% of the cost. Loans of up to 100% are harder to obtain after the financial crisis of 2007–2010.
The same sort of borrowing to buy shares whose dividend
s fall short of interest costs is also called negative gearing. The loan to finance such a transaction is called a margin loan
. This has been very common and pushed by many financial planners during the bull market up to 2008. Importantly the tax treatment is the same, so any investment made where the funding costs exceed the income return is referred to as negative gearing.
Negative gearing payments made by the Australian Commonwealth government to landlords suffering a loss went from $600 million in the 2001-02 tax year to some $3.9 billion in 2004-05. This was also a 50% increase on the previous year.
of negative gearing is as follows.
If interest shortfall is viewed as accumulating in the investment then the deduction means it is compounding pre-tax, and when taxed the rate is the lower capital gains tax. Depreciation and capital works deductions compensate for non-cash expenses of wear and tear
or other progressive deterioration. But if the rates allowed exceed the actual life (e.g. the 2.5% on buildings implies 40 years) then the excess of the deduction lets the taxpayer effectively defer tax liabilities (always an advantage). In the case of capital works that excess would move a small amount of income to capital gain too (the latter taxed at a lower rate).
These rules may also hurt an investor, for instance if one's tax rate while deducting is low but then is high in the capital gain year. Or if a capital loss is incurred then it cannot be claimed against income, only other capital gains.
In any case, the way initial expenses and later gains are treated separately and differently means only a careful and detailed calculation can show the final after-tax return. Assumptions must be made about loan interest rates, maintenance expenses, fittings life, capital appreciation, and future tax rates. Then one can consider risk against benefit.
The above may be contrasted with owner-occupier
s. Mortgage interest and upkeep expenses on a property used for private purposes are not deductible. But any capital gain (or loss) made on disposal of one's primary residence is tax-free. (There are rules to apply when changing a property from private use to rented out, or back, and for what is considered one's main residence.)
Opponents of negative gearing say,
It will be noted a couple of the points on each side are the same thing but interpreted differently. For instance, artificially generated support for the building industry is seen as job creation, although the reality is that it is only moving jobs from other industries to the building industry, an economic distortion. Like much about government policy in economics, it's easy to focus on a particular group that one views as deserving or undeserving, to make a case for or against.
Nothing in gearing and its tax treatment is specific to real estate, so it may just as easily be said to encourage investment (or overinvestment) in any asset class. In practice however investor expectations create a preference for property. Property is considered by many to be a "sure thing" or almost so, i.e. always stable or rising, so owning as much as possible is the aim, with cash to pay the loans the only limiting factor.
A certain amount of hype surrounds negative gearing, especially from those selling services to investors. Taxpayers on the top rate of 48.5% (for 2006, including the Medicare
levy of 1.5%) are eager to hear of present tax benefits, and may merely assume future gains will follow. But any strategy making initial losses
will cost the investor after-tax money, which must be made up by future after-tax gains before it can be worthwhile.
Changes to the tax thresholds and progressive rates to compensate for 'bracket creep' or reduce tax for median earners have made negative gearing less attractive and lucrative for loss-making landlords and potential negative gearers. Thresholds have been increased and rates reduced, meaning less money is returned to the loss-maker.
/Keating
government quarantined negative gearing interest expenses (on new transactions), so interest could only be claimed against rental income, not other income. (Any excess could be carried forward for use in later years.)
The result was a considerable dampening of investor enthusiasm; although the new capital gains tax introduced shortly afterwards (September 1985) may have contributed too. After intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, the government restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.
With the present tax treatment reinstated, the immediate effect was to further increase house prices as investors returned to the market before new construction could catch up.
The political result of this exercise was to put the subject of negative gearing practically off-limits to both major parties ever since. Neither wishes to be seen as contemplating any change to the system, for fear of what it may do to the rental market and/or the property market or building industry.
Changes to the tax system (1987 reintroduction of negative gearing) did lead to an increasing number of investors simply chasing tax deductions via property investment. Armed with the belief that property always goes up, investors were attracted by the reduction in taxes paid (negative gearing). This trend was reinforced by the introduction of the 50% discount on any capital gain for property held for more than one year. However, the lack of any sensible relationship to long term sustainable rental yields has been ignored. This myopic strategy has “led to a surge in property investment in Australia” yet “. . total net rental income from investment properties has decreased from +$219m in 1999/00 to -$8,628m in 2007/08”, meaning that ordinary Australian taxpayers are increasingly subsidising property speculation.
cited systemic tax advantage, including negative gearing, as the main reason for housing unaffordability. Point 22 of the RBA's submission to the Productivity Commission
First Home Ownership Inquiry stated: "most sensible area to look for moderation of demand is among investors” as “the taxation treatment in Australia is more favourable to investors than is the case in other countries"
"In particular, the following areas appear worthy of further study by the Productivity Commission:
1. ability to negatively gear an investment property when there is little prospect of the property being cash-flow positive for many years;
2. benefit investors receive when property depreciation allowances are 'clawed back' through the capital gains tax;
3. general treatment of property depreciation, including the ability to claim depreciation on loss-making investments."
If housing affordability is, in part at least, a function of government tax policy, then it is not clear why negative gearing deductibility is available for second-hand property. One of the main reasons given for its use is that it encourages property investors to supply accommodation, thereby helping renters. The fact is that the "only investors who actually add to the supply of accommodation are those who build new accommodation. Therefore, if negative gearing deductibility were really intended to maximize the supply of accommodation, it would be allowed only for new construction — not for future purchases of established properties."
The most negative aspect of negative gearing is that the tax advantage offered on second-hand properties gets capitalised into prices, thus reducing rental yield and yet requiring larger mortgages to be taken out by investors than would be the case without this tax deduction.
In 2008, the Senate Housing Housing Affordability report echoed findings of the 2004 Productivity Commission report. One recommendation to the enquiry suggested that 'Negative gearing' should be capped and that "There should not be unlimited access. Millionaires and billionaires should not be able to access it, and you should not be able to access it on your 20th investment property. There should be limits to it.
Negative gearing
Negative gearing is a form of leveraged speculation in which a speculator borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan...
is a form of financial leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
where an investor
Investor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
borrows money to buy an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
, but the income generated by that asset does not cover the interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
on the loan. The investor must fund the shortfall until the asset is sold, at which point a profit
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
is made if the capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
on the asset exceeds the accumulated loss.
The tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
treatment of interest expenses and future gain affects the investor's final return. Tax rules vary from country to country. Losses from negative-geared property investments are currently tax-deductible in Canada, Australia, and New Zealand, which are all countries in the Commonwealth of Nations
Commonwealth of Nations
The Commonwealth of Nations, normally referred to as the Commonwealth and formerly known as the British Commonwealth, is an intergovernmental organisation of fifty-four independent member states...
.
Australia
In AustraliaAustralia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
, negative gearing usually refers to borrowing for a residential investment (e.g. a house or unit) which is rented out. In most places rents are less than the interest on property value, and the investment thus results negative gearing if the investor borrows, for instance, 80% or 90% of the cost. Loans of up to 100% are harder to obtain after the financial crisis of 2007–2010.
The same sort of borrowing to buy shares whose dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s fall short of interest costs is also called negative gearing. The loan to finance such a transaction is called a margin loan
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
. This has been very common and pushed by many financial planners during the bull market up to 2008. Importantly the tax treatment is the same, so any investment made where the funding costs exceed the income return is referred to as negative gearing.
Negative gearing payments made by the Australian Commonwealth government to landlords suffering a loss went from $600 million in the 2001-02 tax year to some $3.9 billion in 2004-05. This was also a 50% increase on the previous year.
Taxation
Australian tax treatmentTaxation in Australia
There are many forms of taxation in Australia. Individuals and companies in Australia may be required to pay taxes or charges to all levels of government: local, state, and federal governments...
of negative gearing is as follows.
- Interest on an investment loan for an income producing purpose is fully deductible, even if the income falls short of the interest. Any shortfall ends up offsetting income from other sources, such as the wageWageA wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
and salarySalaryA salary is a form of periodic payment from an employer to an employee, which may be specified in an employment contract. It is contrasted with piece wages, where each job, hour or other unit is paid separately, rather than on a periodic basis....
income of the investor. - Ongoing maintenance and small expenses are similarly fully deductible.
- Property fixtures and fittings are treated as plant, and a deduction for depreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
is allowed, based on effective life. When later sold the difference between actual proceeds and the written-down value becomes income, or further deduction. - Capital works (buildings or major additions, constructed after 1987 or certain other dates) receive a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is on the initial cost (or an estimate), until exhausted. The investor's cost base for capital gains tax purposes is reduced by the amount claimed.
- On sale, capital gains taxCapital gains tax in AustraliaCapital gains tax in the context of the Australian taxation system applies to the capital gain made on disposal of any asset, except for specific exemptions. The most significant exemption is the family home...
is payable on proceeds less cost base (and excluding items treated as plant above). A net capital gain is taxed as income, but if the asset was held for 1 year or more than the gain is first discounted by 50% for an individual, or 33 1/3% for a superannuation fund. (This discount commenced in 1999, prior to that a cost base indexing and a stretching of marginal rates applied instead.)
If interest shortfall is viewed as accumulating in the investment then the deduction means it is compounding pre-tax, and when taxed the rate is the lower capital gains tax. Depreciation and capital works deductions compensate for non-cash expenses of wear and tear
Wear and tear
Wear and tear is damage that naturally and inevitably occurs as a result of normal wear or aging. It is used in a legal context for such areas as warranty contracts from manufacturers, which usually stipulate that damage due to wear and tear will not be covered.Wear and tear is a form of...
or other progressive deterioration. But if the rates allowed exceed the actual life (e.g. the 2.5% on buildings implies 40 years) then the excess of the deduction lets the taxpayer effectively defer tax liabilities (always an advantage). In the case of capital works that excess would move a small amount of income to capital gain too (the latter taxed at a lower rate).
These rules may also hurt an investor, for instance if one's tax rate while deducting is low but then is high in the capital gain year. Or if a capital loss is incurred then it cannot be claimed against income, only other capital gains.
In any case, the way initial expenses and later gains are treated separately and differently means only a careful and detailed calculation can show the final after-tax return. Assumptions must be made about loan interest rates, maintenance expenses, fittings life, capital appreciation, and future tax rates. Then one can consider risk against benefit.
The above may be contrasted with owner-occupier
Owner-occupier
An owner-occupier is a person who lives in and owns the same home. It is a type of housing tenure. The home of the owner-occupier may be, for example, a house, apartment, condominium, or a housing cooperative...
s. Mortgage interest and upkeep expenses on a property used for private purposes are not deductible. But any capital gain (or loss) made on disposal of one's primary residence is tax-free. (There are rules to apply when changing a property from private use to rented out, or back, and for what is considered one's main residence.)
Social Matters
The economic and social effects of negative gearing in Australia are a matter of ongoing debate. Those in favour of negative gearing say- Negatively geared investors support the private residential tenancy market, assisting those who cannot afford to buy, and reducing demand on government public housingPublic housingPublic housing is a form of housing tenure in which the property is owned by a government authority, which may be central or local. Social housing is an umbrella term referring to rental housing which may be owned and managed by the state, by non-profit organizations, or by a combination of the...
. - Investor demand for property supports the building industry, creating employmentEmploymentEmployment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
.(Highly contentious) - Tax benefits encourage individuals to invest and save, especially to help them become self-sufficient in retirement.
- Startup losses are accepted as deductions for business, and should also be accepted for investors, since investors will be taxed on the result.
- Interest expenses deductible to the investor are income to the lender, so there's no loss of tax revenue.
Opponents of negative gearing say,
- It encourages over-investment in residential property, an essentially "unproductive" asset, which is an economic distortion.
- Investors inflate the residential property market, making it less affordable for first home buyers or other owner-occupiers.
- It is effectively a large subsidy from people who are working and saving to people who are borrowing and speculating.
- In Australia in 2007, 9 out of 10 negatively geared properties are for existing dwellings, so the creation of rental supply comes almost entirely at the expense of displacing potential owner-occupiers. Thus, if negative gearing is to exist, it should only be applied to newly constructed properties.
- It encourages speculators into the property market, inflating for instance the Australian property bubble that began in the mid-1990s, partly the result of increased availability of credit that occurred following the entry of non-bank lenders into the Australian mortgage market.
- Tax deductions and overall benefits accrue to those who already have high incomes. This will make the rich investors even richer and the poorer population even poorer. If this prolongs and create a social divide, it will bring the Australian society back to middle age, where there was a clear gap between landlord and peasants (landlords and renters). (One can see from the rules above that the break-even point for those on high tax is less than the break-even for those on low tax, though the latter then give up a lesser portion if they make an overall gain.)
- Tax deductions reduce government revenue by a significant amount each year, which either represents non-investors subsidising investors, or makes the government less able to provide other programs.
- A negatively geared property never generates net income, so losses should not be deductible. (Deductibility of for example business losses when there was a reasonable expectation of gaining income is well-accepted, the point against negative gearing is that it will never generate income. Opponents of full deductibility would presumably at least allow losses to be capitalized into the investor's cost base.)
It will be noted a couple of the points on each side are the same thing but interpreted differently. For instance, artificially generated support for the building industry is seen as job creation, although the reality is that it is only moving jobs from other industries to the building industry, an economic distortion. Like much about government policy in economics, it's easy to focus on a particular group that one views as deserving or undeserving, to make a case for or against.
Nothing in gearing and its tax treatment is specific to real estate, so it may just as easily be said to encourage investment (or overinvestment) in any asset class. In practice however investor expectations create a preference for property. Property is considered by many to be a "sure thing" or almost so, i.e. always stable or rising, so owning as much as possible is the aim, with cash to pay the loans the only limiting factor.
A certain amount of hype surrounds negative gearing, especially from those selling services to investors. Taxpayers on the top rate of 48.5% (for 2006, including the Medicare
Medicare (Australia)
Medicare is Australia's publicly funded universal health care system, operated by the government authority Medicare Australia. Medicare is intended to provide affordable treatment by doctors and in public hospitals for all resident citizens and permanent residents except for those on Norfolk Island...
levy of 1.5%) are eager to hear of present tax benefits, and may merely assume future gains will follow. But any strategy making initial losses
will cost the investor after-tax money, which must be made up by future after-tax gains before it can be worthwhile.
Changes to the tax thresholds and progressive rates to compensate for 'bracket creep' or reduce tax for median earners have made negative gearing less attractive and lucrative for loss-making landlords and potential negative gearers. Thresholds have been increased and rates reduced, meaning less money is returned to the loss-maker.
Political History
In July 1985 the HawkeBob Hawke
Robert James Lee "Bob" Hawke AC GCL was the 23rd Prime Minister of Australia from March 1983 to December 1991 and therefore longest serving Australian Labor Party Prime Minister....
/Keating
Paul Keating
Paul John Keating was the 24th Prime Minister of Australia, serving from 1991 to 1996. Keating was elected as the federal Labor member for Blaxland in 1969 and came to prominence as the reformist treasurer of the Hawke Labor government, which came to power at the 1983 election...
government quarantined negative gearing interest expenses (on new transactions), so interest could only be claimed against rental income, not other income. (Any excess could be carried forward for use in later years.)
The result was a considerable dampening of investor enthusiasm; although the new capital gains tax introduced shortly afterwards (September 1985) may have contributed too. After intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, the government restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.
With the present tax treatment reinstated, the immediate effect was to further increase house prices as investors returned to the market before new construction could catch up.
The political result of this exercise was to put the subject of negative gearing practically off-limits to both major parties ever since. Neither wishes to be seen as contemplating any change to the system, for fear of what it may do to the rental market and/or the property market or building industry.
An alternate view of a costly exercise
The popular view that the temporary removal of negative gearing caused rents to rise has been challenged by two separate studies. The first study, which examined Real Estate Institute data, found that rents rose in Sydney and Perth, but did not find any discernable increase in rents in other State capital cities. The second study, which examined Australian Bureau of Statistics rental data, found that rents rose in Sydney and Perth, remained flat in Melbourne and Adelaide, but fell in Brisbane. Both studies suggest that the property industry's claims about the impact of negative gearing on rents are false. Since if it was true that the abolition of negative gearing caused rents to rise, rents should have risen Australia-wide since negative gearing affects all rental markets equally.Changes to the tax system (1987 reintroduction of negative gearing) did lead to an increasing number of investors simply chasing tax deductions via property investment. Armed with the belief that property always goes up, investors were attracted by the reduction in taxes paid (negative gearing). This trend was reinforced by the introduction of the 50% discount on any capital gain for property held for more than one year. However, the lack of any sensible relationship to long term sustainable rental yields has been ignored. This myopic strategy has “led to a surge in property investment in Australia” yet “. . total net rental income from investment properties has decreased from +$219m in 1999/00 to -$8,628m in 2007/08”, meaning that ordinary Australian taxpayers are increasingly subsidising property speculation.
Effect on Housing Affordability
In 2003, the Reserve Bank of Australia RBARBA
RBA has several uses including:* Rig Builders Alliance* Radial Basis Function* Radiobinding assay* Ranger Body Armor* Relative byte address* Relative Bio Availability* Reserve Bank of Australia* Retail Bakers of America...
cited systemic tax advantage, including negative gearing, as the main reason for housing unaffordability. Point 22 of the RBA's submission to the Productivity Commission
Productivity Commission
The Productivity Commission is the Australian Government's principal review and advisory body on microeconomic policy and regulation. It is an independent statutory authority in the Treasury Portfolio and responds to references from the Treasurer...
First Home Ownership Inquiry stated: "most sensible area to look for moderation of demand is among investors” as “the taxation treatment in Australia is more favourable to investors than is the case in other countries"
"In particular, the following areas appear worthy of further study by the Productivity Commission:
1. ability to negatively gear an investment property when there is little prospect of the property being cash-flow positive for many years;
2. benefit investors receive when property depreciation allowances are 'clawed back' through the capital gains tax;
3. general treatment of property depreciation, including the ability to claim depreciation on loss-making investments."
If housing affordability is, in part at least, a function of government tax policy, then it is not clear why negative gearing deductibility is available for second-hand property. One of the main reasons given for its use is that it encourages property investors to supply accommodation, thereby helping renters. The fact is that the "only investors who actually add to the supply of accommodation are those who build new accommodation. Therefore, if negative gearing deductibility were really intended to maximize the supply of accommodation, it would be allowed only for new construction — not for future purchases of established properties."
The most negative aspect of negative gearing is that the tax advantage offered on second-hand properties gets capitalised into prices, thus reducing rental yield and yet requiring larger mortgages to be taken out by investors than would be the case without this tax deduction.
In 2008, the Senate Housing Housing Affordability report echoed findings of the 2004 Productivity Commission report. One recommendation to the enquiry suggested that 'Negative gearing' should be capped and that "There should not be unlimited access. Millionaires and billionaires should not be able to access it, and you should not be able to access it on your 20th investment property. There should be limits to it.
Canada and New Zealand
Negative gearing is permissible in Canada and New Zealand, but the taxation and finance regulation systems do not permit it to take place on such a large scale as in Australia.External links
- Australian Democrats Negative Gearing Issue Sheet for the 2004 Election (PDF)
- Australian Taxation Office Rental Properties Guide 2005, product NAT 1729-6.2005
- Real Estate Institute of Australia Policy Statement on Negative Gearing, as of October 2005
- Negative Gearing—A Commentary on how it works and who it is suited to
- A Brief Overview of Negative Gearing in Australia