Another view on tax and negative gearing for property investors | Pete Wargent

Of all the exams I had to sit to become a Chartered Accountant, the one I found trickiest to get my head around was tax.

Not only was Britain operating under an archaic schedular tax system, there were seemingly trillions of silly rules with no apparent rhyme nor reason to them (and there was no such thing as an “open book exam” in those days).

The complexity of tax legislation is not too surprising when you think about it.

It was the Magna Carta itself in 1215 which laid down the fundamentals of today’s tax law, including the rather salient point that the King now had to actually ask for consent before demanding taxes from the populace.

Next year will of course mark the 800th anniversary of the signing of the Magna Carta, and what a phenomenally complex and intricate tax legislation has evolved over those centuries since.

Inextricably linked

The tax laws don’t operate in isolation.

A bit like Newton’s Third Law, for every action there often an equal and opposite reaction.

Or in the case of tax law, several reactions.link

Amendments to tax legislation are complicated and therefore must should pass rigorous modelling as well act Acts of Parliament before being adopted and administrated by Her Majesty’s Revenue & Customs (HMRC).

Notably, tax legislation is usually amended via the consultation of tax experts and rarely is it adopted at the behest of bloggers, comments from punters on Facebook or from debates held in the Twittersphere.

On an obliquely related note this year the Bank of England allowed queries to be asked of the institution via a Twitter hashtag (#askBoE), but one suspects that will be the first and last time it undertakes the offering of such an olive branch of approach-ability following a cascade of facetious questioning and strongly-worded suggestions.

Britain’s schedular system of taxation was cleaned up in part by a new act around a decade ago, while Australia has no such schedular system of taxation in place.

Negative about gearing?

Indeed, it is exactly this fact that Australia does not operate under such a schedular system of tax that has been causing so much debate in recent times with respect to so-termed “negative gearing” (NG) legislation, the existence of which allows investors in property to offset net rental losses plus depreciation allowances against current year salary income (this is not allowable in Britain, for example).

While it is doubtful anyone would create a new set of tax laws today which allowed for such an offset (more typically, a loss in an investment class could be carried forward to be offset against gains from the same asset class), some of the ongoing arguments used for necessarily scrapping NG are painfully oversimplified.

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One of the favourite lines of reasoning is that government could “save” several billion dollars simply by “scrapping” the legislation.

Setting aside the fact the the legislation reflects timing differences and losses claimed should or could theoretically be offset by future rental gains, it is also important to consider Newton’s Law and the opposite reactions.

Ignoring the argument of whether or not rents would rise sharply as they did in Sydney and Perth when the NG rules were previously quarantined for two years from 1985, if the desired effect of quelling investment activity is achieved, what of the stamp duty foregone?

What of the rapidly reduced corporation taxes collected from developers and materials businesses as fewer dwellings are constructed when prices are dampened (as would surely eventuate)?

More pertinently, if waiting lists for public housing spiral by nearly 30 percent in New South Walesas they did between 1985 and 1987, who picks up the tab for that?

I’m not saying there aren’t achievable work-arounds for each of these points, but it does seem to me that the key point is that driving down prices would result in an immediate capitulation of the dwelling construction boom which has been engineered by higher prices since the middle of 2012.

This point seems to be overlooked or more usually ignored every time the debate takes place, although I did notice it referred to by Ross Guest in an article this week.negative

Moreover, were the full impacts of lower housing prices to be modelled the tax take might well look very different to a supposed saving of several billion.

Ed Chan, an accountant who unlike me does specialise in tax, argued that scrapping negative gearing could potentially cripple government budgets in costing hundreds of million dollars in public housing expenditure.

There is no need for another drawn-out debate on the merits or otherwise of the legislation here since most people have long since adopted their positions based on their own housing status and tax position, only to note that the rules will not be scrapped outright for the reasons listed above.

Legislation may be amended prospectively, though, in particular restricting new claimants to losses made on new dwellings.

We’ll have to wait and see.

Replacement cost

The thing about large cities with strongly growing populations, of which Australia has four, is that prices should ultimately oscillate close to their replacement cost, which is why capital city housing tends to be a good inflation hedge.hammer-and-nail

It is possible to force prices below replacement cost for a time but then construction will quickly cease, only to fire up again once prices are acceptably above replacement cost.

In short, I have no doubt whatsoever that the scrapping or quarantining of negative gearing rules would cause dwelling prices to temporarily ease, but if the outcome is the end of the construction cycle and a chronic housing shortage eventuates in Sydney then the merits may not be no great.

If these points seem somewhat circular, that is because housing markets are naturally cyclical. At this stage in the cycle we should be seeing more supply which will eventually bring rentals costs under control and the price cycle will pass its peak in due course.

Population growth adds to the challenges

Of course, tax legislation is one thing, but Australia’s rampant population growth, a policy doubtless in part adopted in order to keep the tax dollars flowing in, is quite another.

Although we believe that population growth will slow markedly as the year progresses, the data released last week which I analysed here showed that population growth has exploded higher in New South Wales by 114,500 persons in the 12 months to March 2014.

While population growth was slower (and slowing) elsewhere a total annual population growth of 388,000 persons puts great strain on housing in four capital cities in particular: Sydney, Melbourne, Perth and Brisbane.

Over the past year New South Wales (+114,500), Victoria (+108,800), Queensland (+75,800) and Western Australia (+63,400) accounted for all of the materially significant population growth in Australia covering off a massive 93.3 percent of the total. This continues the long run trend of population growth being heavily focused on these four states.

Note that more than 230,000 or around 60 percent of that population growth was due to net migration, although this figure will slow as the year progresses.

The long term population growth figures in New South Wales, Victoria, Queensland and Western Australia tell their own story.

Australia’s population policy is in part driven by the desire to replace the rapidly ageing workforce with new younger taxpayers, which gives us an enviable population pyramid when compared to most developed countries but may come at the expense of GDP per capita…and high house prices in Sydney and Melbourne.

While we continue to add 80,000 to 90,000 people to our largest cities each year, this represents a huge underlying demand for housing.



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Pete Wargent

About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


'Another view on tax and negative gearing for property investors | Pete Wargent' have 3 comments

  1. October 6, 2014 @ 5:53 am aushousingcrash on twitter

    Any removal of NG would need to be offset by some incentives to build/buy new for at least some buyer cohort.
    What are your thoughts on the effect on the market if Hockey was to cap the dollar amount of NG deduction allowable to say a value of $10k per individual? Politically doable in this climate!!

    Reply

  2. October 6, 2014 @ 1:55 pm Hamish

    Given the number of investment properties held by investors seems to be around 1 and a bit, the bigger question to ask is – generally how long does it take for a typical property to go from being negatively to positively geared?

    Other things to think about include:
    – depreciation claw back on sale – the cost base is reduced for CGT purposes when calculating the gain (noting the 50% reduction applies)

    – the deductibility of the loan depends on the purpose. How many people are borrowing against the increase in value of their investment property to fund renovations on their home? And then claiming the interest as deductible? This is illegal.

    Reply

  3. October 9, 2014 @ 10:31 pm Greg Coggiola

    I have been self employed as a sole trader for the last 20 years and prior to that when I left PAYG employment I had only a very small Superannuation account.

    There was no compulsory super deductions in those days. So in order to plan for my retirement I decided that I would invest in property as my superannuation. The return from my property holdings has been substantially better than would have been possible had I invested the little spare money I had from my business into a superannuation scheme.

    Property has allowed me to gear up my investment and negative gearing has made it a little easier for me to sustain the ongoing costs up to this point. Fortunately I am close to being neutral and then no doubt positively geared in my retirement.

    It annoys me when people claim negative gearing is a rort and should be abolished. However if the generous tax concessions these people benefit from, with their super schemes were abolished, you can be assured there would be a huge outcry.

    I have chosen the path of self super through property investment.
    This will enable me to
    1. NOT be a burden on tax payers when i retire
    2.Continue to supply housing to people as the government is clearly not in a position to fund public housing on mass. Which would be a further burden on the governments balance sheet.
    3.Leave a legacy to my children which will if managed properly, be a source of income for them, in turn reducing their reliance on the government for welfare.

    Receiving tax breaks through negative gearing is no different to business people with their myriad of tax deductions or
    hundreds of thousands of people receiving tax breaks through superannuation schemes.

    Reply


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