Capital city property prices have soared in recent years, as have the tax deductions claimed on “negatively geared” investment properties. As a result, housing affordability and negative gearing are back on the political agenda.
Property can be an emotive topic, as many Australians – both individuals and businesses – have a vested interest in seeing property prices continue to march onwards and upwards. Calls to end or severely curtail negative gearing are met with fierce resistance.
If you’re not familiar with negative gearing (at least in the property sphere), it’s the practice of borrowing to buy an investment property, where the interest and other property expenses exceed the rental income received. The net annual loss is claimed as a tax deduction against other income including, in many cases, the investor’s salary.
Negative gearing discussions often getting bogged down in arguments over its impact on property prices and rents, or the tax rules that apply to other investments. Let’s put away the crystal balls and tax books and take a look at what makes negative gearing tick.
Consider a simple example. Hugh is looking to buy an established Sydney property that will cost him $1 million (including stamp duty and other transaction costs). After deducting property related expenses, he’ll earn $30,000 in net annual rent.
His mortgage broker has told him that, by using the equity in his home, he can borrow the full $1 million at an interest rate of 5 per cent. If he subtracts his interest expense from his rental income, the deal will net Hugh an annual loss of $20,000. Hugh is a lawyer, so he’s got a good job that pays good money; in fact he’s on the top marginal tax rate of 47 per cent (including Medicare levy, but excluding the “debt levy”). This means that each year the negative gearing tax deduction will save him $9400 in tax. Extrapolated over five years, Hugh will lose $100,000 (before tax). At first blush that doesn’t sound great, but Hugh decides to proceed because (a) the ATO is effectively wearing half the cost and (b) he expects the property to be worth a lot more five years from now than it is today, netting him a capital gain.
The beauty (from Hugh’s perspective) is that capital gains are discounted (by 50 per cent) before being taxed. So if he makes a $200,000 capital gain, his tax bill will be $47,000. That’s just enough to offset the tax his negative gearing deductions saved him during the previous five years.
Overall, Hugh nets $100,000 cash profit and pays zero tax. Even if he makes a $500,000 capital gain, his effective overall tax rate will end up being less than 20 per cent. In fact, it’s almost impossible to imagine a scenario where Hugh will end up paying more than 20 per cent of his profits to the ATO – happy days for Hugh.
What if things don’t go so well for Hugh’s investment? One of the main risks to property investors is rising interest rates. Let’s look at what happens if interest rates increase to 8 per cent and the property value remains flat.
In this scenario, as you might expect, Hugh makes a large (tax deductible) loss. Assuming the interest rate increase was immediate, he’d lose $250,000 over the five-year period. Unfortunately for the ATO, while it doesn’t see much of any potential capital gain, it wears 47 per cent of his losses – $117,500.
What the negative gearing rules – the combination of upfront interest deductions and discounted capital gains – create is a financial bet that’s skewed heavily in Hugh’s favour. If things go swimmingly, the bulk of the profit goes to Hugh and if things go badly, he splits the losses roughly 50/50 with the ATO. With a tax bet skewed in their favour, property prices rising and interest rates at record lows, it’s no wonder investors are borrowing large sums to jump aboard the property train.
Negative gearing remains one of the last great Australian tax holidays but, even at today’s low interest rates, it’s costing the federal budget $4 billion a year. It’s unlikely to be sustainable forever.
The talk has been of changing the rules for future investors only, so existing property owners shouldn’t be affected. But let the discussion serve as a reminder to keep your mortgage payments where you can afford them, with or without the taxman’s help.
Richard Livingston is a founder of Eviser ( www.eviser.com.au).
This article contains general investment advice only (under AFSL 469838).