How Would Assets Perform if Negative Gearing Was Removed? | John Edwards

Don’t Believe all the Hype About Property Prices and the effect of negative Gearing.

Abnormally high property prices, and the dramatic decrease of affordability in Australian housing markets, are spurring reactions.negative-gearing-silver

Negative gearing tax benefits, in drawing housing asset investors into the property market, is perceived to be crowding out first home buyers.

Anyone who can guess how investors would react to the loss of a tax break can assume that removing negative gearing would pull some investors out of the property market.

This could relieve pressure on purchases and lower house prices.

Many would see this as welcome.

However, there is an unintended consequence of a reduction in the amount of investment properties purchased:

It could worsen the living standards of renters by causing dollar weekly rents to increase.

neg gearThis would be the case if enough investors pulled out of property investing, limiting the supply of dwellings available for rent.

Further, rental rates could be subject to increase as investors increased the rentals in an attempt to maintain rates of return.

The only way we can understand the likely impact is to model the investment with and without negative gearing using actual data that obtained over the past decades.

Residex has this data and has developed the required models to show just what would happen if negative gearing was removed.

The analysis shows that that the provision of negative gearing is still necessary but its analysis shows that excessive gearing carries significant risk in both return and tax terms.

In this report we provide a summary of our analysis and findings.

Analysing the Impact of Negative Gearing

An important issue to remember in all situations where the removal of a tax benefit to an investor is considered, is the fact that the benefit on the surface may appear to be a benefit to the recipient.

In reality, it is a benefit to the ultimate user of the asset.

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This is because as you reduce the return or benefit an investor is receiving with respect to one particular asset class, the investor has one of two options;

1. Exit the market and no longer provide the resource for which the benefit was being provided. Funds would then go in an alternative asset class where the returns are better.

Or;

2. Increase the cost of the provision of the asset to maintain the return that was acceptable and being derived from the asset.

The impact of the first option has the same impact as the second, as market forces will cause increases in the cost of the use of the asset, simply because the available volume of the resource in the market will have been reduced, causing increased competition for the resource that is available.

One other point before we move to empirical analysis:

It is better if all asset sectors are treated similarly.

negativeThis will mitigate distortions in markets, and see investment decisions based on the fundamental quality and return of the asset – not on the benefits that are available as a consequence of some form of special government incentive.

In the case of negative gearing, its removal would result in property being treated differently for tax purposes to other asset class investments.

There is nothing which stops an investor from buying a business in their name, the business producing a loss, and those losses being offset against the other income of the investor.

Investors could hold a negatively geared share portfolio and achieve the same negative gearing benefit as is available currently from investing in property if they wished.

In essence, to remove the negative gearing benefit from property investment and not other investments would be creating a market distortion.

Notwithstanding all of the above…

What one cannot do is enter a transaction with the main purpose of reducing your tax liability.

To do this would be contrary to the provision of Part IV A of the Tax Act (anti avoidance provisions).tax_time

Equally, if you are entering the transaction on the basis that you will make profits from capital gains only, and not from rental cash, then you are trading in property.

Property traders are not entitled to the capital gains tax benefits.

Clearly, when you look at the current position in terms of this, it will be clear to most that there are many transactions that should be challenged by the Commissioner of Taxation, and significant deductions not allowed.

Perhaps the problem here simply is the fact that the Tax Act is not being enforced strictly enough.

Obvious excessive gearing, which on any reasonable modelling indicates that a party could not make loan repayments without the tax loss, should be challenged.

house mortgageThe exception to this is if it can be shown reasonably that the investor is expecting that the property will, during their anticipated holding period, produce rental returns that will cause the property to produce annual, taxable profits.

A simple statement by the Tax Commissioner that transactions which are geared in excess of a specified level, and produce tax losses annually, will be challenged under Part IV A, would solve the problem.

To this extent, the Tax office might issue guidelines to allow people to understand when they are potentially overstepping the mark.

At this point it is worth recognising the fact that it is not the Tax office’s fault that there has not been stricter management of residential property investment.

It is more an issue for the Federal Treasury.

The Tax office is the instrument of the Federal Treasury, and the Tax Office acts in terms of their direction.

Equally, it has to have the required staff to implement rules and regulations.money_house

Before we specifically consider some transactions to gain an understanding of the tax issues, we consider the position in risk terms.

We start with the scenario of a world without negative gearing incentive for assets.

This means you cannot claim losses from an investment property, shares or bonds against your other personal income tax.

How Assets Would Perform if Negative Gearing Was Removed

A computer model, developed by Residex, identified the rate of total return from a particular asset, given the removal of negative gearing.

house fall priceThis after tax return is adjusted for inflation.

The model also identifies the risk associated with each asset.

‘Risk’ is the probability that the real return will be lower than inflation.

Other models were also constructed where the risk was assessed on the variability in the return.

The outcomes from the models pointed to similar findings.

The assets considered are:

1. Houses and Units in Sydney, Melbourne and Brisbane

In other words land and dwelling assets in the cities.

The performance is identified from a total rate of return being the aggregate of both capital growth and rental yield as calculated by Residex.

2. Sharesideas

The published index for the ALLORDS, together with the dividend information relevant to that index*.

3. Short Term Cash

The 90 Day Bank Bill rates as published by the Reserve Bank of Australia.

4. 10 Year Commonwealth Government Bonds

The rate as published by the Reserve Bank of Australia.

Comparing these different assets allows us to understand the market environment following the removal of negative gearing.

Our results are based on the assumption that this would stop investors from borrowing at a rate where assets would return at a loss over their full investment term.

In other words, leveraging would have to be much lower.

The results can be seen in Graph 1.

Graph 1: Removal of Negative Gearing from Investments

Negative-Gearing-table

In Graph 1 we present the seven year holding case where negative gearing has been removed.

The outcome presented is the median outcome of a seven year investment taken out at any time over the last 30 plus years.

The result from a return perspective, with respect to property, is poor.

It is only Melbourne dwellings that have a better return than the ALLORDS.

market update house

In fact, the returns of both Sydney and Brisbane are less than the 50% leveraged case of the ALLORDS.

Additionally, Graph 1 shows that removing negative gearing benefits on property substantially increased risk for all dwelling sectors, and the risk is exceedingly high for Sydney and Brisbane and in fact the ALLORDS has a lower level of risk and the probability of these two asset sectors providing a return better than inflation is approaching only 50 per cent for Brisbane and 60 per cent for Sydney.

In a situation where a market performs poorly in terms of rental and capital growth, the removal of negative gearing increases the impact of any demand and supply adjustment.

Hence, the removal of negative gearing increases the chance of a major market correction and significant general economic adjustment.

If a market starts to adjust, then that adjustment is amplified.

interest rate signThis increases the risk of significant asset disposals which deflate values.

Equally, without negative gearing, any increase in interest rates makes it more difficult for the investor.

Interest rate movements currently do not have a significant impact on tenants.

However, the removal of negative gearing would have a larger impact on this group as investors would be more often forced to increase rentals as interest rates increased, or dispose of the investment.

A Tax Solution to Negative Gearing Issues

It needs to be recognised that excessive investment activity does impact on prices as demand is increased.strategy

Consequently, first home buyers and others with limited cash resources are excluded from the market.

The unit market is predominately the place of the investor, while investment activity in the house and land market is limited.

It is difficult to identify the impact of investors on the market.

Given their increased activity in the unit market it is probably reasonable to assume that at least 30% of the growth can be attributed to investor activity (this is the share of the market that is generally recognised as being rented).

This suggests that, in the year to September 2014, investors caused unit prices to increase by approximately $21,000.

This is a very significant amount in the eyes of the young first home buyer and probably more than they could save in two years.

Table 1: Outcome (Aggresive)

Table 2: Outcome (Sensible)

Not only does excessive investment impact on prices, it also impacts on Federal Government revenues.

There are approximately 10 million properties in Australia.

If we assume 12.5 per cent of these is receiving negative gearing benefits (a conservative estimate as there are more than 30 per cent of all properties rented in Australia), then assuming the average negative gearing tax claim per property is in the order of $15,000 per annum, the total deductions claimed by Australian tax payers is in the order of $20 billion plus per annum.

This sharply puts into focus the issues with respect to negative gearing.australia

Our investor is usually an existing home owner who has significant equity in their family home.

This means that they can leverage against that equity and in many cases borrow the full amount of the investment property.

However, let’s assume for a start that our investor is not proposing to do that.

The investor has about $24,000 in cash and needs to borrow the balance to buy the median Sydney unit property which has a cost of about $585,000. In Table 1, we present the result of this investment which is made on the various assumptions stated.

In this case the investor never receives rental cash from the investment which exceeds the interest charges.

This is a fairly typical negatively geared property.

However, what the investor does receive is profit from the sale.

In this example one has to wonder what the purpose of the transaction was.house money loan

It had to be clear that there could never be expected profit from rentals on any reasonable assumption.

The only benefit available to the investor could come when the property is sold.

The investor is clearly trading in the property’s future value.

They are buying the property with the purpose of future sale for a profit.

As a consequence they are not entitled the capital gains tax benefits.

Clearly, the higher we leverage, the more evident that the investor is either investing for the purpose of profits from sale or is solely seeking to access tax deductions and reduce tax and hence falling into the anti avoidance legislation.

We consider one further example where we take a more acceptable leveraged case.

This example is provided in Table 2 to illustrate the situation where the investor’s actions are reasonable on all fronts and could not be questioned by the authorities.

In this case there are still negative gearing benefits but at times during the investment, rental income does exceed interest deductions. The only problem is the fact that the investor has to have significant upfront cash to allow the investment to occur.

So what is the solution to the issue?

Clearly the Tax Office does not have sufficient staff to review all tax returns of investors.

money-crystal-ball---The task would be very significant and require large numbers of staff.

As a consequence, the tax office needs to be given additional staff to manage the current position.

At the same time, it needs to let the public know what is acceptable and what is unacceptable.

It could do this by way of a general tax ruling indicating that where its guidelines are not followed, it will proceed to take action in the courts.

This would be an actionable threat as it would find many examples in the population’s tax returns where it would have an exceedingly strong case and every likelihood of success in the courts.

In essence, the ruling should simply state that any party investing in residential property who leverages in excess of 80 per cent will be subject to scrutiny and could be subject to the anti-avoidance legislation.

TaxesFurther, they should state that when the investment property is sold in the event that at no time did rental income exceed interest deductions for a reasonable period then the tax office would consider the purpose of the property investment was to create a trading activity and the investment would not be entitled to the benefits of the Capital Gains Tax regime.

If this was done there will probably be numerous, very technical reasons that tax lawyers would find to suggest that it is inappropriate.

However, in reality this action would simply put the nation on notice and present a level of risk to investors if they followed the aggressive gearing path which would probably be unacceptable and the problem would be removed.

negative-gearing-silverEqually, the current issues which are being raised by the Reserve Bank and its measures which are being considered would no longer be necessary.

Our proposal is a simple and effective solution, which could be implemented very easily and would not require any legislative change.

Equally, it would allow the tax office to look at existing transactions as properties are sold.

Overall, negative gearing is necessary.

It is a subsidy in favour of the poor who are renting and encourages the provision of stock for this group of people.

Perhaps the only valid criticism is the fact that potentially it is sometimes being allowed by Federal Government authorities when it should not be.



Want more of this type of information?


John Edwards

About

John is Consulting Analyst for Onthehouse, Australia’s most comprehensive real estate portal, and Founder of Residex, a leading Australian research organisation providing quality information on the real estate market to government, financial institutions, valuers, real estate agents, accountants, solicitors and the general public. Visit www.OnTheHouse.com.au/


'How Would Assets Perform if Negative Gearing Was Removed? | John Edwards' have 2 comments

  1. January 30, 2015 @ 11:19 am LMN

    Excellent article, thanks so much for posting. I have both residential and commercial property. I was just wondering, what impact, if any, would this have on commercial property transactions and income?

    Reply

    • January 30, 2015 @ 11:24 am Michael Yardney

      Hi
      Commercial properties are more yield driven investments,buy also have significant depreciable items that make them tax effective.

      Private investors in commercial properties would be similarly impacted

      Reply


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