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If negative gearing is scrapped what will it mean for property investment?

Lately negative gearing for property investment has come under siege, with calls to scrap this tax incentive for property investors.

Just to make things clear…negative gearing is leveraged speculation whereby a speculator borrows funds to buy an asset, but the income from the asset fails to cover the interest repayable on the loan.

In Australia, the interest on the loan may currently be offset against other income thus facilitating a tax deduction.

Punters may therefore be compelled to speculate in assets which generate a cash-flow loss in the hope of a future capital gain. This is true in shares and particularly the case in residential property.
Negative gearing under siege
It is very fashionable at the moment to blame high property prices in Australia squarely upon the practice of negative gearing.
The theory is that the prevailing laws should be scrapped, speculators would exit the property market and the values of properties would decline markedly.
This may or may not be the case.
Today, let’s take a look at the other side of this argument, and particularly why the Government has not simply pressed ahead with this course of action.
Why doesn’t the Government simply scrap these tax laws?
Well, they tried to.
In 1985, the Labor Government rescinded the negative gearing tax laws and yet was forced to reintroduce them just two years later in 1987 (Labor then suggesting that the new capital gains tax rules should instead act as a deterrent to speculators).
Booming rents
The main problem facing the Government, so the argument goes, was a shortage of available rental properties.
Some commentators like to cherry-pick numbers and suggest that in some cities rents did not increase between 1985 and 1987. That may indeed be true, but also in some cities (namely Perth and Sydney) rents absolutely sky-rocketed.
It is easy to blame incessant lobbying from the real estate industry for the re-introduction of the negative gearing incentives, but the counter-argument is that much of the backlash actually came from tenants in those cities who were shocked by the spiralling rents.
Social housing funding
The other argument for scrapping negative gearing rules is that the Government could save itself billions in tax revenues. Again, this is partly true, but there is a flip side, and this is that social housing funding would presumably be increased.
Between 1985 and 1987 the numbers on the NSW social housing waiting list increased alarmingly by around 40% from fewer than 110,000 to 140,000, a trend that was immediately reversed upon the re-introduction of the previous ruling on interest deductions.Of course, many other countries do not have equivalent negative gearing tax laws, but in some cases this may equate to a higher percentage of the population (particularly in certain socialist countries) becoming reliant upon the state for social housing, an outcome which brings with it its own hefty costs.
4 reasons property investors don’t fear the gear
So why aren’t property investors more worried about the incentives being abolished? Here are 4 reasons:
1 – Lack of retrospective application
In 1985, the new laws were not made retrospective so existing property investors were not impacted.
2 – Compensating laws?
At the time of the scrapping of the negative gearing rules, the Government was seemingly aware of a need to introduce other incentives and thus introduced a 4% capital allowance on the construction cost of new buildings to be offset against new income.
The idea was to encourage investors to invest in new properties to alleviate the rental property shortage, but overall, it would probably be fair to say that the allowance was ineffective.
3 – Lower interest rates
Negative gearing in property became very popular in the 1980s when interest rates were significantly higher than they are today.
Whether the structural shift to lower interest rates since 1990 proves to be a permanent one remains to be seen, but negative gearing rules are of diminished importance to investors when interest rates are lower as they are now.
4 – Increasing rents
If negative gearing laws are abolished, rents would probably increase, which would act as some compensation for property investors.
Summary
Periodically, the negative gearing tax laws will come under review.
It seems unlikely that they would be scrapped outright and overnight, but they may well be phased out over time.
Smart investors do not worry unduly about changes in political and tax regimes but instead align themselves to the shifting markets.
There will always be underperforming and outperforming assets, and educated investors simply aim to move with the changing times.

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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


'If negative gearing is scrapped what will it mean for property investment?' have 7 comments

  1. Avatar for Property Update

    October 31, 2012 @ 7:10 am Nigel

    Check out the recent experience in NZ. The removal of depreciation as a tax deductible allowance from April 2011 has not dented investors enthusiasm, or brought down values…..

    Reply

    • Avatar for Property Update

      October 31, 2012 @ 7:22 am Michael Yardney

      Hi Nigel – great to hear from you – How’s the NZ property market behaving?
      I see depreciation as a very different and smaller issue than negative gearing but watch out for my blog on the topic of negative gearing on Friday.
      By the way…It’s a pity you couldn’t make it to the Property Development Workshop. It was a great 3 days and sold out 2 weeks in advance

      Reply

  2. Avatar for Property Update

    October 31, 2012 @ 9:32 am paul

    what, are you trying to give us a heart attack???

    Reply

    • Avatar for Property Update

      October 31, 2012 @ 10:27 am Michael Yardney

      Paul
      There are those out there who are lobbying for abolition of negative gearing. I’ll give ou my thoughts in my blog on Friday – watch out for it

      Reply

      • Avatar for Property Update

        October 31, 2012 @ 10:35 am Pete Wargent

        Hi Paul, don’t shoot the messenger! :-)

        Amendments to the negative gearing rules were a recommendation of the Ken Henry tax review of 2008/09 (though the recommendation was a cap rather than abolition of the ruling altogether).

        Fortunately for negatively geared property investors Treasurer Wayne Swan and PM Julia Gillard did not go down that path. As for the future…who knows?

        Pete

        Reply

  3. Avatar for Property Update

    October 31, 2012 @ 8:36 pm Billy

    Thanks Pete and Michael for your regular articles, I found this one interesting in particular, as property affordability groups usually hold this issue almost solely accountable for most of Australia’s housing affordability problems…

    My reasoning may be flawed and perhaps some light will be shed on it in Michael’s article tomorrow, but let us say hypothetically the government DOES cut negative gearing. In my view, wouldn’t this merely change the buying criteria for only 30% of the Australian property market, that being the new investors?

    If I were buying an IP with no tax benefits at all, I would seek a property with an outstanding track record even if it costs much more than a regular house because the capital gains would outstrip the extra cost of subsidising it (which is what any good property investor does anyway) and as a consequence make these suburbs even more expensive and cause more urban sprawl, then we are back to where we are now?

    Surely most of the other 70% owner occupiers wouldn’t know any different and go about their business and push the prices up/push prices down with their greed/fear plus inflation to assist, as per usual in the cycle. Then these groups and doomsayers would need another scapegoat!

    Cheers, Billy

    Reply

  4. Avatar for Property Update

    October 31, 2012 @ 9:29 pm Pete Wargent

    Hi Billy,

    I agree with what you say, though I do suppose that depends on whether any new ruling were to be applied retrospectively (very doubtful).

    The argument of the lobbyists, of course, is that any hint of a change might cause a disorderly procession for the exits. That seems unlikely to me; but a disclaimer: that’s only my opinion.

    Ultimately, none of us really know. In any case, our discussion is purely hypothetical until such time as a government dares to tamper with the rules again! And they haven’t – for a very long time now.

    Cheers for the kind comments by they way!

    Pete

    Reply


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