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Investing in Sydney and the Nitty-Gritty of Negative Gearing | John Edwards

We have often spoken about the issue of a two speed economy.tortoise-and-hare

In the past few years, we were referring to the significant economic activity in the resource states compared to sluggish performance in the non-resource states.

Today however, there is a deeper divide developing between the two – not in general economic activities – but in the housing markets.

In Table 1, ‘Monthly Summary’ we provide the growth rates for our markets as at the end of October 2014. This table clearly shows the very strong growth in Sydney and the significant price differences between the markets.

Table 1: Monthly Summary

Sydney has been the more expensive capital city since the early 1970’s.

In recent times, it has gained another mantle: by far, it is to become the most unaffordable city in Australia with the median household, buying the median house, having only $754 per week after tax and after loan repayments to spend on the necessities of life.

This is very clearly an unacceptable position. A unit purchase does generate a better position, but even then, the purchase of the median unit only improves things by about $300 per week.

negative-gearing-silver

Normally, there is an alternative to avoid the difficulty of being over extended by buying a home, and that is renting.

However, this too is not really a solution as rentals are also prohibitively expensive.

The after tax cash of the median family after entering a rental for the median home is only about $300 per week better than it would be if they purchased. The position for a unit rental is worse with the difference being a meagre $100 per week.

From the perspective of old, established investors (the baby boomers), the current position is terrific, with returns over the last few years looking very attractive.

Clearly something has to give. There is always a counter balance to any profound, long term economic change in the environment.

We have seen such a profound change in the economic environment since the Global Financial Crisis (GFC); the change being historically low interest rates.

These low interest rates have occurred at a time when there is, and has been, uncertainty with respect to the security of share investments and a growing need by the baby boomers to grow their retirement funds to allow them to live comfortably in the future.

The one asset these baby boomers have seen deliver a constant return without too much disruption is the family home.

house

They have grown in many cases wealthy from their investment. To understand their strong leaning to property investment, just consider the typical baby boomer who purchased their home in Sydney in, say, 1975.

Their return over the period was better than 9.3 per cent per annum. It would be exceptionally difficult to find an asset which did better on an after tax basis.Their home would have cost them about $27,000. Today, that home will be worth something in the order of $875,000.

Given the above, there should be no surprise that our baby boomers are strongly motivated to grow their wealth and encourage others to do the same by investing in residential property.

What else can we expect in a situation where there is little return from making bank deposits or buying bonds? Additionally, while the stock market has recently been doing relatively well, most of our baby boomers will have had some very salutary lessons delivered by the GFC from investing in shares.

The growth in the baby boomers wealth has given them added power in terms of the capacity to borrow to further their wealth generation process.

Furthermore, the changes to superannuation, which now allows borrowings, effectively allowing leverage of the super fund, is again leading this group into aggressive investment activity in the residential market place.

house money

We have learnt from experience that where there is ample opportunity, or limited constraint, on people with respect to the capacity to borrow and buy, then they will bid up property values beyond the real value.

This is what is happening currently. The baby boomer investor currently has limited constraint on accessing funds due to the large level of equity many have in the family home.

The constraint that should be there is being voided because many are unaware of the restrictions which exist with respect to negative gearing.

Equally, bankers and financial advisers are not helping to urge people seeking investment loans to obtain detailed taxation advice. The constraint is simply that you can’t negatively gear for the full period of the investment.

You have to be able, on reasonable basis, to demonstrate that there is a likelihood of the investment returning taxable income over a reasonable investment period. In most cases, for the investor to be able to do this in the current environment where interest rates are at historical lows and will increase shortly, the investor will need to have a substantial deposit.

The deposit would probably be better than 10 per cent.

The position is not helped by government failing to provide adequate resources in the Australian Tax Office to allow the Tax Office to pursue those who are failing to comply with the requirements of the taxation legislation.

low interest rates

The problem for the government is significant as there is probably more than $20 billion in tax deductions being claimed annually as a result of negative gearing.

This will ultimately cause government to take some type of action. The action we do not want is the removal of negative gearing for a vast number of reasons.

What is the possible outcome for the investor if they are claiming negative gearing deductions where there is no reasonable chance of their investment ever providing taxable profits from rental income? There are two possible results:

  • The commissioner denies all deductions and levies fines. This is because he can claim that you were engaged in tax avoidance.
    He can claim that without tax deductions, you would not have entered into the transaction.
  • Alternatively, he could run the case that, as you were never going to make any profits from the transaction, other than from the sale of the property, you were in the business of trading in residential property.
    In this situation, your ability to claim the concessional capital gains tax benefits can only be subjected to tax with respect to 50 per cent of the capital gain that would be lost.

To this point, one can probably assume that the commissioner has not followed the above path; the task of looking at all investors’ tax returns would be very significant, and the return on the effort is probably judged as not being worthwhile.

At least this probably was the case.

However, as the number of people involved in residential property investment has now grown significantly, the benefit will not be so little.

Given this situation, we should all take note and make sure we understand the tax risks we may be taking.

I believe it would be appropriate for the commissioner to issue a general tax guideline or ruling so all can understand the complexity of negative gearing and what the rules are that need to be complied with to ensure ordinary people are not at risk, and are not unintentionally breaking the law.

[sam id=37 codes=’true’]

Most ordinary people I speak to simply believe there are no rules.

They believe they can simply borrow as much as they would like and have a property negatively geared for the full term of their investment.

To let the current position continue would ultimately result in negative gearing being removed.

This would be inappropriate, and not in the best interests of the Australian economy.

We would have another unnecessary distorting piece of legislation related to the housing market.



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About

Michael is a director of Metropole Property Strategists who help their clients grow, protect and pass on their wealth through independent, unbiased property advice and advocacy. He's once again been voted Australia's leading property investment adviser and his opinions are regularly featured in the media. Visit Metropole.com.au


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