Negative Gearing Tax Policy: How It Works (And Why It's Unfair)

Negative gearing is a very controversial issue. The latest round of debate stems from the Reserve Bank's submission to the House of Representative Standing Committee on Economics regarding the enquiry into home ownership. The Bank believed that "there is a case for reviewing negative gearing". According to some, it's a patently unfair tax policy. Here's why.

Treasurer Joe Hockey promptly responded to the Reserve Bank's submission by ruling out any change of the tax policy on negative gearing. In particular, it was reported that he claimed that removing negative gearing would create "an exception to a standing rule in taxation law".

Is negative gearing in accordance with well-established tax rules? A fundamental principle in the tax law is that a taxpayer should be able to deduct expenses only if the expenses have been incurred to generate assessable income.

This is why an employee can only deduct expenses that are sufficiently related to work. For example, a funeral director at tropical Queensland would be able to deduct the cost of his black jacket (but not his black trousers) because the ATO believes that no rational person – except a funeral director – would wear a black jacket in such a hot place.

Should mortgage interest on an investment property be deductible? Investment properties generate two kinds of income: rental income and capital gains (if any). As capital gains on investment property can enjoy a 50% tax discount if the property has been held for at least a year, strictly speaking only 50% of the interest expenses related to the capital gain should be deductible.

In practice, it is impossible to predict whether there will eventually be a capital gain, and also impossible to predict the amount of the gain. This presents the key difficulty in the design of the tax policy on negative gearing.

Allowing full deduction of the interest expenses every year effectively allows deduction of expenses that may be incurred to generate the tax free portion of the capital gain (if any), and therefore may violate the fundamental tax principle for deductions. However, how can the Australian Tax Office (ATO) determine how much of the interest expenses should be disallowed every year before the investment property is actually sold?

Many countries resolve this issue by quarantining losses on investment properties. It means that losses generated from negative gearing cannot be used to offset against other sources of income, for example, salaries or business income. Instead, the losses can be carried forward to future years to offset against income from the investment properties.

This policy is fair in the sense that the same tax principle for deductions applies to both taxpayers with and without negative gearing. Many countries adopt this quarantine policy, including major developed countries such as the US, the UK, France and Japan.

Some countries have even stricter tax rules on investment properties. For example, China allows a fixed 20% deduction of the rental income, and the Netherlands tax property investors on a deemed yield rate of 4% on the value of the properties. In other words, these countries do not allow deduction of any tax losses on investment properties at all.

Australia's current tax policy on negative gearing seems overly generous when compared to both groups of countries. More importantly, it is not fair to taxpayers who do not have negative gearing. The policy effectively subsidies negative geared property investors through the tax system.

The Reserve Bank concluded its submission to the enquiry into home ownership by rightly stating that "policy should not unduly advantage property investors at the expense of prospective owner-occupier home buyers … tax and regulatory frameworks should avoid encouraging over-leveraging into property".

Of course, the negative gearing issue is complex and highly political. The ATO's Tax Statistics for 2012-13 showed that taxpayers claimed a total of $12 billion tax losses from investment properties, and almost 1.3 million taxpayers had negative gearing.

The sheer number of taxpayers currently enjoying the benefit of negative gearing dictates that it will demand strong political will and leadership before a politician is willing to propose changes to the current tax rule on negative gearing.

Even if the government is bold enough to change the rule, careful consideration has to be given to transition rules to cater for the existing taxpayers that have negative gearing. This is a story for another day.

The ConversationAntony Ting is Associate Professor at University of Sydney.

This article was originally published on The Conversation.


Comments

    Aren't all our politicians property rich with large portfolio's? Vested interest?

      Yeah apparently the parliament average is 2.5 properties per MP.

    The RBA also said in their submission ....

    To the extent that negative gearing induces landlords to accept a lower rental yield than otherwise (at least while continued capital gains are expected), it may be helpful for housing affordability for tenants.

    Higher rents anyone ? Negative gearing allows landlords to absorb a loss - this gives renters lower rents to help them save for a deposit faster.

    Who is really going to benefit by it's removal ? I reckon it will be the wealthy who aren't -ve gearing at the currently low interest rates when they start collecting higher rents.

      Rents are dictated by the renter's ability to pay.

      Or do you think landlords are charging less rent than they otherwise could be ?

      Rents in Sydney are already ridiculous. Its cheaper for me to rent by myself in Melbourne than it is to rent with roommates in Sydney.
      The state government and local councils have royally screwed up the planning of this city.

      As far as I'm concerned you can keep your Negative gearing and I will relocate and go work overseas.

      That makes the assumption that rent consumers have the capability to absorb higher rents. I propose that in Sydney, they do not. There are already 8 young overseas students packed into 2BR apartments in World Square because that's all they can afford. If you're not accustomed to overcrowded living conditions of a 'developing country' back home, you're probably not going to accept this as a lifestyle and will go to Adelaide, Brisbane, and so on to get away from it. The poster is right from the standpoint of, if profits go down, sellers tend to increase prices to compensate for that, to bring profit back up... but if nobody's buying (in this case, signing leases), they're limited in how much they can do that, if at all.

      Auinvestor, you don't think rent prices are some what connected to supply and demand?

      I've already seen prices go down where I live, from "you must offer $50 more a week to get ahead of the 40 other applicants" to "Oh sure $50 less than asking price? Better than being vacant". The market dictates the price. It'll be a messy couple of years while the market adjusts, but it will adjust, and when it's not a guaranteed profit making investment, housing prices will stop climbing so ridiculously.

      See the words "to the extent that..." before the bit that you put in bold? Those words are pretty important.

    I feel a few things should be pointed out

    The crucial point to this whole issue is capital gains - negative gearing is only a 'subsidy' in a market with strong growth potential, remember that you're actually spending that money to make a loss in the hope of gaining a huge windfall in a number of years. It's quite possible you could lose overall, we're just used to meteoric rises in property values (mainly in Syd/Mel)

    Second, as the article points out, all our income streams are bunched together - we can claim deductions for all together, so technically we could spend more on work expenses than we earn from work and deduct it from rent

    This is unlikely - but the real point here is that we pay our progessive rate of marginal taxation on everything - rent, capital gains, interest, dividends etc and if you're an average worker that means that any income you receive from say, an investment property, is likely to be at the higher end of the MTR (especially capital gains), so you're looking at a likely tax rate of 39.5% to 49.5%

    That's a massive tax rate, and if we start quarantining losses (which really means quarantining income streams), we'll need new tax rates for rent, cgt etc and trust me, the government won't be taking close to 50% then (and bear in mind the 50% discount is a quick solution to accounting for inflation, if generous, this would be still be a factor in a quaratined system)

    and no I don't have a negative geared property

    "Antony Ting is Associate Professor at University of Sydney." Associate Professor of what?

    A flawed premise here. Capital gain is not "another kind of income". Rental income and capital gain are each taxed in the year they are received by the taxpayer. Expenses incurred in the current year are deducted against income in the current year. Future expenses will be offset against future income, in due course when both items are known. I don't understand how any of this is a problem.
    And by the way, residential property is the only consumer durable that can be rented for less than its cost of ownership. Is that also unfair?

      Residential property being rented for less than the cost of ownership is a symptom of the problem, not an argument that there isn't a problem.

    This article misses the point completely, but then I would expect that from an academic.

    Negative gearing is the ability to claim a net loss (rental income - interest - depreciation) against your other income.

    The cost base for the purpose of calculating the capital gain is reduced by the depreciation. So this amount is "clawed back" on eventual sale.

    Separately, same with any asset held by a person (does not apply to companies), there is a 50% reduction in the amount included in their taxable income on sale of the property.

    In the US the rate of tax on capital gains (and dividends) is 15%. They don't have dividend imputation but the rate of tax on dividends is lower.

    So the question about negative gearing is - if the net loss is denied (i.e. can't offset against other types of income) then can it be carried forward an offset against net rental income in the future and / or capital gains. This just deferes the issue but does not eliminate the ability to claim a loss.

    Capital losses currently work this way i.e. they can be carried forward but are only able to be claimed against future capital gains.

    The real problem is not in allowing full interest to be deducted against immediately, it the disconnect with unknown future capital gains that are only assessed on sale. The 'easy' solution is the leave the interest deductions as they are, and change capital gains to be assessed annually, based on independent valuation or accepted percentages (similar to depreciation).

    This also solves another problem with deferred capital gains of it being assessed in one year, potentially at a higher marginal rate. Current system benefits those already paying top marginal rate with deferred tax obligation, subsidised by those not paying the highest marginal rate.

    Capital gains assessment should be annualised in the same manner as depreciation.

    There is a housing shortage.
    So, there needs to be incentives for property development and investment (ownership).
    Super funds can now invest in property, and that negative gearing plays a role in appreciation strategies.
    There's lots of formal super in property, and masses and masses of informal 'retirement equity' in primary residential home ownership.

    If they touch negative gearing - heed these words

    Investors will exit the property market - the property market will flood - rents will bottom out as desperate owners compete with each other for renters to cover investment loans - the Australian economy will implode because this will wipe out non-investing home owners (remembering that no-one has the super they need, but don't really care because since there is no capital gain on sale of primary residence, non-investing home owners literally have their futures sunk into the appreciation in their home, so wiping out housing prices meaning wiping out most Australian's retirement plans) people will be looking to sell for less than they bought for rather than carry an increasing debt on an asset turned liability - anyone in property (including home owners) will be wiped out - the banks will turn to government for bailouts - does any of this sound familiar...?

      The property market does not need 20% year-on-year gains in full asset price given to people who put 20% down (read: they double the money they put in, in a year, plus take deductions). Property would still be an attractive investment at a far smaller gain. Say, you put $100K into a $500K property to buy it. In a year, that property is worth $600K. Sell, pay off the mortgage, and you're still left with $200K instead of the $100K you had 12 months prior. (Yes, I know this ignores stamp duty, cost of sale, etc. .... I've simplified it.) That's an unrealistic level of return to subsidise to the extent that Australia's tax system does.

        Selling for cap gain is a rare event in property investment. Maybe we search strategies and see why holding & harvesting equity for further investment makes the scenario you reference somewhat irrelevant (also, 20% value lift in 1 year is also very very rare).

      Negative gearing on new properties only for somewhere in the range of 5-10 years sounds far more reasonable than the current system. It encourages development, reduces housing shortages, and stops people from speculatively investing in large, old, single residence housing.

        Nope -investment is a long term strategy, downturns in the market often force those looking to exit to hold longer. Making a 5 or 10 year rule would still precipitate the collapse scenario.

    Negative gearing is bad tax policy, but its prominence is a symptom of a larger problem - our broken property market.

    In a properly functioning property market negative gearing would not be an issue because in a properly functioning real estate market landlords have a positive yield (ie: aren't losing money each week) and capital gain is typically minimal (in line with inflation).

      Agreed. Housing should be for housing, not gambling. Investment properties should be based upon a steady income stream, a la rent, and not windfall gains in the form of capital gains.
      Also, if investors didn't borrow so much on an investment property, then they would make more on rent.
      Also, if investors didn't game the market with speculation, prospective home buyers wouldn't have to be competing in what is now an investors game just to put walls and a roof around themselves and their families. This is also one of the major contributing to the growing divide between the rich and poor in Australia.

        I understand your altruistic perspective. The scenario you describe where renters simply cover the mortgage would mean that nobody would get into property for investment - in order for this to happen there would need to be no disparity between supply and a man and of housing, and the only parties making money from property would be lenders and those who were fortunate enough for their property to appreciate. Though I'm not sure that your model would permit property value appreciation as it would drive prices up and make housing less affordable, and so the model would fail. I'm also interested to understand where people without a deposit would live? Are hotels allowed in your model?

          Maybe if they didn't borrow so much on investments, then their mortgage repayments would be smaller.... then the incoming rent would offer profit. I may be over simplifying it, but I stand by the ideal.

          Investment for capital gains is what has ballooned the property market out. To my mind that is exactly the reason property investment is bad.

          This market currently operates with two extremely different objectives, affordable shelter for home buyers and high growth for investors. In this case, the people looking to shelter themselves should have the first priority on how the market operates.

          Invest in Australian stocks instead, they help grow business which ultimately helps the economy. Growing the property market only lines investors wallets.

          The scenario you describe where renters simply cover the mortgage would mean that nobody would get into property for investment [...]

          In functioning property markets, people get into property for investment because the yields from rent are in the high single digits, if not low double digits.

          Ie: they make their money from the rental income, not the capital gain (which in the long term, corner cases aside, should be no more than inflation).

    Maybe the real problem is letting property investors have a 50% deduction on their capital gains? Why, exactly, are we allowing people a tax deduction on capital gains because they have sufficient wealth to invest in property? Why does income from housing speculation merit some kind of beneficial tax treatment - is capital gains housing income somehow "better" income for our society than the income I earn in my 9-5 job?

    It seems like a ridiculously unfair and unneccessary tax break. Once we start taxing capital gains at the same rate as we tax other income, then the taxation gymnastics required to work out how to make tax deductions fair start to become slightly less complicated.

      The problem is that if I sell my investment property after (say) 20 years, the top marginal tax rate of 48.5% applies to practically all of the capital gain, which is practically all of the sale price. That makes the total tax rate on the sale about double what you pay out of a typical PAYG income.
      And further on CGT rates, owner occupiers get a 100% exemption. Is that fair to people who rent all their lives? "Fairness" is a very flexible concept.

        I don't really understand this. The capital gain is the difference between the purchase price and the sale price - not "practically all of the sale price". At the moment if you buy a house for $100,000 and you sell it for $200,000, you have made a capital gain of $100,000.

        Now, I'm no master of "fairness", but I'm not entirely sure why you think there should be any tax exemptions on your $100,000 profit here.

        Maybe you're arguing that inflation should be taken into account, or something? Or are you arguing that you should be able to split the capital gain over the 20 years. So you could argue that you've earned $5,000 per year? Well, that's an interesting argument and I see how it makes a kind of sense - but you've also got up to 20 years of interest free tax avoidance the value of the capital growth you haven't been paying tax on has remained securely invested in your house. So you've been reaping a reward for locking your money away from the tax man all that time as well. Presuming you were also earning other income during this time, it's a bit of a stretch to argue that you wouldn't have been paying somewhere near the top marginal rate on that $5000 per year income during those 20 years anyway.

        Splitting capital growth over multiple years isn't possible in any investment. Peopel have to take this kind of thing into account with every other investment on the market, why should it be any different with housing.

        Sure, I agree with you that the 100% exemption on CGT for owner occupiers isn't fair. It's not. Especially now that we live in a world where only the wealthier among us will be able to own the house they live in. It's fast becoming yet another special tax rort for those who need it least.

        I have to admit I think that housing and our Australian penchant for investing in it is a giant anchor on the Australian economy. The amount of money tied rather uselessly up in these fairly unproductive assets is a crying shame. Housing investments should not be a first choice for investors wanting to make the best returns - housing should be a "safe" conservative investment with low growth and high security. Instead it's a high security high growth investment market that sucks all the risk taking finance out of the rest of our economy.

        Last edited 20/07/15 9:20 am

        The problem is that if I sell my investment property after (say) 20 years, the top marginal tax rate of 48.5% applies to practically all of the capital gain [...]

        No it doesn't.

        If you have held the asset for twenty years, half of your capital gain (minus any time you were using it as a PPoR) is subject to your marginal tax rate.

        Now, if you're in the top tax bracket, and thus the top 5% of income earners in the country, AND have a house that you bought twenty years ago when real prices were 1/3 to 1/4 what they are today, then you'll have to wait a minute while I find a tiny violin to play.

      Rules and laws are not unfair. These rules and laws apply to you just as they apply to others. If they have worked out how to maximise their returns under the same rules and laws as you, maybe there is a knowledge gap. It might be worth digging into our property investment works and you may realise that anyone can get in and do well. It's not magic, tens of thousands maybe hundreds of thousands of Australians are doing it.

        Now hun, we know you like the way things are but 'rules and laws are not unfair'.
        Those rules are about to change, and that is 'not unfair', so you'll just have to look at a second economic strategy.
        2 strategies in one lifetime, imagine that. I guess you'll just have to deal with it dear. Your grandfather and I walked to school through a snowstorm carrying the teachers' milk supplies on our backs. Then we went to work in the salt mines so you could have a nice future and complain about your lounge being lumpy.
        So stop the damn potty mouth and let the people play nice. Then go to another $50 get rich seminar when there's a new investment strategy.

          Now hun, we know you like the way things are but 'rules and laws are not unfair'.
          Those rules are about to change, and that is 'not unfair', so you'll just have to look at a second economic strategy.

          I'm not adverse to change (I'm staring to think they should change the rules and laws about assisted suicide).

          2 strategies in one lifetime, imagine that. I guess you'll just have to deal with it dear. Your grandfather and I walked to school through a snowstorm carrying the teachers' milk supplies on our backs. Then we went to work in the salt mines so you could have a nice future and complain about your lounge being lumpy.
          I'm familiar with strategy diversification, I am simply pointing out that the property market is high because it attracts investment and supply is lower than demand - and - that non-investing home owners will get wiped out if negative gearing is touched.

          So stop the damn potty mouth and let the people play nice. Then go to another $50 get rich seminar when there's a new investment strategy.
          No potty mouth from me - & if a seminar is only $50, no one's going to get rich by attending.

    This country needs to get rid of negative gearing on property even if it is long and involves a grandfathering arrangement. (this would reduce the problems mentioned by @Kendal)
    We need an asset tax based on the grounds that if you have more than say $2 to $5 million in assets you pay a yearly tax on those assets.
    This would change the inequitable system we have now.

      Why do we need to get rid of negative gearing? Seriously. What's the actual reason?

        We have an inequitable system now. Removing negative gearing would be just one part to make the tax system more equal.

          The tax system applies to everyone though, you can't say there's an inequality issue. You know Australia is the one of the fastest and easiest countries to start a business in right? And that no one is prevented from working trusts and other mechanisms to minimise tax exposure right? I am telling you - if negative gearing is touched, the economy will be shot to bits, starting with non-investing home owners who were hoping to sell and live off the capital gain which would be wiped out.

            The tax system applies to everyone but it is not equal for everyone.
            At the moment the economy is nearly shot to bits (depending on what you read)
            and negative gearing is not the cause but it could add to a short term problem if it is changed and that is why the grandfathering arrangement was included.
            The way things are heading with companies not investing and consumer confidence well down
            there is a big chance of a recession and that is of no good.

        It's primarily a tax dodge that incentivises bad behaviour ("investing" in a loss-making asset to reduce income tax in the hope of making it up later with unrealistic and unearned capital gains).

          Please suggest an alternative to who will pay for houses which lose money.
          Will the rent go up to cover it?
          Will the government find another way t make housing affordable?
          It's not a tax dodge - it's legal, and it's fair, and it means people have houses to live in who could otherwise not afford to live in them (ie, get a deposit or secure of afford a mortgage).
          Will you plan involve shutting down all hotels and motels too?
          Please - do tell.

            Houses that lose money would decrease in price until they make money, like all investments do in properly functioning markets. Yes, this would mean some people have to sell and may even go bankrupt. That's what happens in the grown-up world when you make bad investments .

            Rents would not rise (on the whole - specific areas may vary) as they are set by the renter's ability to pay, not the landlord's operating costs. If landlords could charge more rent, they would already be doing so.

            It is absolutely a tax dodge (it is used to shift tax off income and onto capital gain). Being legal makes it no less so. Novated leasing is another example of something that is legal, but is nothing more than a tax dodge.

            Why on Earth you think hotels and motels are even vaguely relevant to the discussion is beyond me.

              Your 'That's what happens in the grown-up world-' remark is followed by examples which refute your own position on the topic, examples which are also from the same grown-up world, and so by your logic, also valid.

              Please don't ever invest if you're OK with losing money & going bankrupt.

              Actual investors wouldn't do this, and when there is risk, they offset it or exit. That's why dropping negative gearing would kill the economy, because the substantial investment base would deflate housing prices on exit, and primary residential owners depending on the capital gain for their retirement would be wiped out and who's going to pay to keep broke retirees alive and well when the government is so light on tax revenues that they're publicly brainstorming about increasing GST?

              You can't refute these facts.
              They're facts.

                Please don't ever invest if you're OK with losing money & going bankrupt.

                If the possibility of losing everything is not in your investment calculations, you're an irresponsible fool.

                Actual investors wouldn't do this, and when there is risk, they offset it or exit. That's why dropping negative gearing would kill the economy, [...]

                Of course they would, and no it wouldn't. In properly functioning property markets, rental returns are not only positive, but well above the rate of a simple term deposit.

                It's important to understand, that negative gearing is almost unique-to-Australia on a global scale. In most places, if you suggested that losing money on a daily basis in the hope that ongoing arbitrary Government regulation would result in capital growth, you'd be rightfully looked at as a fool.

                Homeowners relying on capital gain of their properties above inflation are speculating - gambling - and should consider themselves nothing more than incredibly lucky if they realise returns above inflation.

                The reluctance of thirty years worth of neoliberal Governments to live up to their responsibilities, vis-a-vis taxation and pensions, is entirely independent of this discussion.

                Last edited 09/08/15 2:54 am

    The reason capital gains "enjoy a 50% tax discount" is to offset the fact that they are not indexed to inflation. To be fair, removing negative gearing would require capital gains calculations to account for inflation.

      Come on dazzlebot - why should the tax system make a special exemption for housing to take into account inflation? It doesn't do that for any other investment.

        Perhaps because other forms of investment don't provide a broad service to the community. Perhaps we should just socialise housing.

        jcleeland - I am not saying housing should get a special exemption. I am saying the system is fine as it is. The argument which was presented for negative gearing being unfair was predicated on capital gains "enjoying a 50% tax discount". I was pointing out that it is not really a discount at all. Nor is it special to real estate: all investments get the 50% discount if held for more than one year.

    I don't have a problem with negative gearing in principle. However, the way it is structured is totally weird. The reason is that interest costs and outgoings are fully deductible at your marginal rate while the capital gains tax is half of your marginal rate. This means that if you ran a scenario where you purchased a house with an LVR of 80%, price growth of 4%pa, interest rate of 5.5% and rental yield of 3% - your after tax return over 5 years would be IDENTICAL to the return you would have generated if we lived in a tax FREE world. What they SHOULD do is use the same tax rate for deductions as they do for capital gains. In other words, if the capital gains tax is half of your marginal rate, then you should deduct at the same rate!

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