Negative gearing arouses passions on both sides: about a third think people are making legitimate deductions, a third think it’s a rort, and a third don’t know. This blog explains how negative gearing works, to help resolve these issues. A more complete analysis of negative gearing can be found in a recent ACOSS report, “Fuel on the fire”.

In negative gearing strategies, investors borrow to buy an asset (such as a rental property), and structure the loan so that interest payments and other costs exceed income from rent. This investment ‘loss’ is then deducted from their other income, such as wages. On the face it, perfectly legitimate: the tax system allows people to deduct their expenses from their income and this is what they’re doing. The puzzle is why people deliberately make losses for many years on their investments. Even if they save on tax, aren’t they losing overall? The answer to this puzzle is the key to understanding how negative gearing works and whether or not it’s a legitimate feature of our income tax system.

How negative gearing works

To illustrate with an example (a simplification, not a real one):

“Ms Invest buys a rental property for $600K, with an annual rental return of $25K (around $500pw)

Her annual running costs (maintenance, agents fees, etc) are $10K

To maximise her borrowing capacity and take advantage of negative gearing arrangements, Ms Invest uses a more expensive ‘interest only’ loan, on which the bank gives her discretion to make higher or lower payments each year, so that the investment consistently makes a cash ‘loss’.

Now, say she borrows 80% of the value of the property (around $500K) and pays $25K a year in interest (5%).

So her annual expenses are $35K and income from rent is $25K: a cash ‘loss’ of $10K before tax.

Ms Invest deducts this $10K ‘loss’ against her wage of $150K (over half of geared property investors earn at least $100K, according to RBA research cited in the ACOSS Report).

Her marginal tax rate is 39% (including the Medicare Levy). So the tax saving from this deduction is around $4K. Taking this into account, she’s making an annual after-tax cash ‘loss’ of $6K a year ($10K – $4K). [there are other tax benefits like building depreciation but let’s set these aside to simplify things]

So why does she do it? The answer – and this is what really drives negatively geared property investments –  is capital gain. That is, the increase in the value of the property each year which Ms Investor will cash in (or ‘realise’) when she eventually sells it. Until then, she can use it to reduce her income tax. When she does sell, only half the increase in the property’s value (the capital gain) is taxed. This ‘50% discount’ was introduced in 1999, just before negative gearing strategies really took off.

Let’s say the property increases in value by 5% a year – which is conservative in capital city property markets today. That’s $30K a year.

So instead of making an annual ‘loss’ of $10K before tax, she’s actually making a profit on the investment of $20K ($30K – $10K). After tax, her annual profit is $18K ($24K on the capital gain minus $6K on the other income and expenses). In effect, taking account of Capital Gains Tax and deductions for expenses, the annual tax rate on her investment is just 10% ($2K divided by $20K).

This is the problem with negative gearing: deductions are being claimed for investment ‘losses’ that aren’t really losses. Ms Invest is making cash ‘losses’ before she sells the property, but then profits when she sells it years later and makes a lightly taxed capital gain.

Solutions

There are three ways to fix this problem.

One option is to tax capital gains each year as they accrue (before the property is sold), at the same marginal tax rate at which the deductions are being claimed (in this case 39%). The problem with this is that Ms Invest might not have the cash-flow to pay this tax, and it would require an annual valuation of the property. This is not a practical option.

A second option, advanced by the Henry Report, is to reduce the tax discount for individual capital gains from 50% to 40% (so that 60% of gains are taxed), and then only allow investors to deduct 60% of their investment expenses. This ensures that gains and losses are at least taxed in the same way: 60% of capital gains are taxed and 60% of the associated losses are deductable (instead of 50% of the gains and 100% of the losses). The problem with this is that there’s still a timing advantage. Ms Invest can claim deductions for many years but is only taxed on the capital gain when the property is sold.  As they say, time is money!

The third option deals with this problem by delaying the deductions. To stop people claiming deductions against investments which aren’t actually making losses, their investment ‘losses’ could no longer be deducted from their wages. Instead they would be ‘quarantined’ and carried forward to be deducted against future cash profits from the investment. If the property is not negatively geared, the expenses could still be deducted as they accrue, so nothing changes. If it is negatively geared, the deductions might be delayed a few years until the investment makes a cash profit (due to lower interest payments and higher rents). In extreme cases they might be delayed until the property is sold, in which case the investment expenses are deducted against the capital gains.

The idea is to ‘ring-fence’ income and losses from an investment so that gains and losses are treated in the same way (symmetrically). The deductions are not denied, they are delayed.

This is not a new idea. It was adopted by the Hawke Government in 1985 (and a mythology has emerged over its impact on rental property investment and rent levels, as explained in the ACOSS Report). Similar rules are in place in most wealthy countries including the United States and United Kingdom (see table).

The same principle is already applied in other areas of Australian tax and social security policy:

• Investment property losses cannot be deducted against other income in the income tests for social security and family payments.
• Trust losses are quarantined within the trust and cannot be offset against the income of the beneficiaries.
• Capital losses are quarantined and carried forward so that they can only be offset against capital gains.
• Some active business losses (e,g, hobby farms) are quarantined and cannot be deducted against the owner’s other income.

These quarantining rules are all designed to tackle a common problem: the tax treatment of investment income and expenses is lopsided. Investment income is taxed concessionally, so allowing unlimited deductions against other income (that’s taxed at ‘normal’ rates) threatens the integrity of the tax system. These rules were developed in response to real problems (rorting of the tax system and revenue leakage), not just theoretical ones.

In the case of negative gearing, the underlying problem is the tax treatment of capital gains. This problem extends well beyond rental property, to geared investment in shares (leveraged equities), agricultural schemes (like the ill-fated Timbercorp), racehorses and works of art – personal investments that mainly yield income in the form of capital gains. The same quarantining rules should apply to these investments.

As the ACOSS Report spells out, this is not just an equity and tax integrity problem: it blunts the efficiency of investment, and the economy. The tax system is encouraging people to borrow more than they otherwise would to punt on the capital gains in the property market.  We’ve seen over the housing booms of the 80s and 00s what this does to housing costs and macro-economic stability. And Timbercorp is a case study of the harm that can come when people are encouraged to invest with tax deductions in mind rather than the quality of the investment.