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How will Labor’s negative gearing rules apply?

(This is a modified version of an article published in TaxVine®, The Tax Institute’s flagship, member-only weekly news service).

If elected in 2019, Federal Labor plans to introduce restrictions on negative gearing for investors. Two weeks ago, I confirmed with the Labor Party that their proposed changes to negative gearing would apply across the board to all investments.

Previously, it was thought that Labor’s negative gearing restrictions might only apply to property investment, as they announced :

Labor will limit negative gearing to new housing from a yet-to-be-determined date after the next election. All investments made before this date will not be affected by this change and will be fully grandfathered.

This will mean that taxpayers will continue to be able to deduct net rental losses against their wage income, providing the losses come from newly constructed housing.

From a yet-to-be-determined date after the next election losses from new investments in shares and existing properties can still be used to offset investment income tax liabilities. These losses can also continue to be carried forward to offset the final capital gain on the investment.

This article examines some practical examples of how Labor’s restrictions might operate. I make no political statement, either on my own behalf, or on behalf of The Tax Institute.

In summary, under the proposals, the excess of interest expense over income (such as rent or dividends) cannot be utilised against salary and wage income. It must be carried forward for offset in future years against future investment income or capital gains from the disposal of the investment assets.

Negative gearing: how big is the problem?

Although interest rates have been at record lows for many years, negative gearing remains pronounced as rental returns have also fallen. Interest rates of 4 to 5 % and rental returns of 2 to 3% are common profiles giving rise to negative gearing, albeit far more modest than when interest rates were at 15%-plus levels back in the 1980s. (That may provide some explanation for the failure of negative gearing reforms in the mid-1980s – but that is another story!)

Further, in the context of margin lending to fund share acquisitions, interest rates are usually into double digit levels. While some shares pay dividends much higher than the often-paltry returns achieved on property investments (think RIO 7.19% BHP 7.02% CBA 8.94%), that is not always the case (think CSL 1.24% QBE 2.57% Aristocrat 2.12%).

Labor’s figures suggest an improvement to the Federal Budget bottom line of $32 billion over 10 years. That figure, I believe, relates to both negative gearing and the proposed halving of the capital gains tax (CGT) discount from 50% to 25% so the exact tax contribution from negative gearing restrictions is unclear. Nonetheless, it does seem that Labor expects a substantial return from the change.

The scope of Labor’s proposed measures

After some interrogation, I have confirmed that Labor’s restrictions on negative gearing will apply (after a yet-to-be announced commencement date) to all investments on a global basis to every taxpayer. In other words, it will apply to property and shares and any other relevant asset class. It will look at a taxpayer and assess their overall investment income measured against their overall investment interest expenses.

Both these points are critical to an understanding of what is proposed.

What does this mean for investors in a practical sense?

Let me illustrate what this means for investors with three examples.

Example 1 - Harry

After the proposed commencement date, Harry, an Australian resident, borrows $500,000 from a bank and uses the borrowed funds to buy an investment property in suburban Melbourne. The interest rate is 5% per year and the net return (after all deductions other than interest) is 3.5% net per year. Harry is employed deriving PAYG income of $200,000 per year but has no other investments, geared or otherwise.

Example 2 - Raylene

After the proposed commencement date, Raylene, an Australian resident, borrows $500,000 under a margin loan arrangement and uses the borrowed funds to buy shares in an Australian company. The interest rate on the loan is 8% per year and the net return on the shares (after all deductions other than interest) is 2% per year (being the grossed-up dividend yield on CSL, QBE and Aristocrat combined, for example). Raylene is employed deriving PAYG income of $300,000 per year but has no other investments, geared or otherwise.

Example 3 - Suellen

After the proposed commencement date, Suellen, an Australian resident, borrows $1,000,000 from a bank at a 5% per year interest rate and uses the borrowed funds to:

  • buy a property for $500,000 which has a net rent (before interest) of 3%; and
  • buy shares in an Australian listed public company which will pay a grossed-up dividend yield of 5%.

In addition, Suellen uses $500,000 of her own funds to purchase 5-year treasury bonds, paying her an interest rate of 2% per year (I assume treasury bonds will be covered by the restrictions).

The restrictions on negative gearing will need to be carefully monitored by all three people.

Harry and Raylene will both fall foul of the proposed negative gearing restrictions as their interest expense exceeds the income – in Harry’s case by $7,500 and Raylene’s case by $30,000 (that is, interest expense of $40,000 or 8% of $500,000 minus $10,000 dividend or 2% of $500,000).

Under current rules, that excess could have been used to offset other income earned by Harry and Raylene giving rise to tax savings of $3,375 for Harry and $13,500 for Raylene. Under Labor’s proposals, the excess cannot be so utilised but must be carried forward for offset in future years against future investment income or capital gains from the disposal of the investment assets.

Their position will need to be looked at afresh every year as their circumstances may change. If, for example, the interest rate falls and the rent rises, the property may become positively geared (or just less negatively geared). In addition, they may buy new assets with better gearing ratios, in which case the problem may again be reduced or even completely eliminated.

Suellen, on the other hand, owns property bought with borrowed funds, shares bought with borrowed funds and bonds bought with her own funds. She will not have a negative gearing problem. Her total interest expense is $50,000 but her total investment income from the three sources is $50,000. She will be able to fully utilise the losses which she makes through the negative gearing of her property and share portfolio essentially through the positive gearing of the bond portfolio.

It's bad news for Harry and Raylene but okay for Suellen. No doubt she might also prefer a life without the added drama of watching the negative gearing ceiling but with careful planning she can manage the process.

This is the key to dealing with the fallout from Labor’s restrictions. Management of portfolios should have regard to the restrictions on negative gearing.

In addition, purchasing properties in the name of the family member best able to manage any negative gearing restrictions will also be vital.

Finally, while I believe this interpretation is conceptually consistent with what Labor has announced, much will depend on the detail of the legislation. Sometimes the detail can surprise and can be inconsistent with the conceptual foundations.

 

Professor Robert Deutsch is Senior Tax Counsel at The Tax Institute. This article is for general information only and does not consider the circumstances of any investor.

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15 Comments

Hunter

November 28, 2018

The true cost of this tax change has not been mentioned anywhere. The government should be encouraging investment so less people are reliant on pension when it comes to retirement. The solution for housing affordability is introducing better tax system for the build to rent and housing affordability schemes.

David

December 01, 2018

Hunter, the true cost is not the Labor parties problem as they will only be there one or two terms then it is someone else's problem, the Labor governments attitude appears to be to keep every body highly dependent on them at any cost.
It will be similar to chasing negative returns on an investment which isn't a good idea but at least every body will be involved.
Labors attitude is "It dose not matter, we will just borrow more money and it can be everybody's fault that we are in the crap"
What will happen to the people caught in the middle still saving for there own independence, I think they will get burned the most!
One to two terms is not enough time for any party to fix the bad direction in which we are heading!

Reuben

November 27, 2018

Why would sueleen not just reduce her her gearing level to 50% by using the 500k of her own funds to offset an otherwise 5% interest cost? Then she will be neutrally feared and problem solved. I can’t see why you would invest at 2% when you have debt at 5

Martin

November 26, 2018

It makes good sense to push investors into thinking whether losses are worth incurring to finance a particular investment in the short term, because of long term capital gain. At the moment where the tax break can be taken on earned income, I think a lot of investors see negative gearing as a lower tax bill, and don’t truely understand how much they are speculating. If the property downturn continues, many are in for a rude shock. Helping people understand they are paying less tax only because they are earning less while speculating on the future must surely be a good thing. The policy would be improved if the Suellen loophole was closed and the accumulated losses could only be offset against the specific debt funded investment.

Steve

November 24, 2018

Rule # 1: NEVER qualify an investment on the basis of a "lifelong" tax break. Once you do, you become a speculator not an investor. Tax breaks turn poor investments into good investments and good investments into great investments. And don't the spruikers understand that reality. Clearly, the rise in speculators over recent years (in the property market at least) can be put down to a rather generous tax environment that was never going to last. When those tax incentives are finally removed (either next year or whenever), we will see who has been swimming naked.

Sean Anderson

November 23, 2018

Carrying forward losses like this is interesting. Does this mean it just defers the tax, and then ultimately taxes it as capital which attracts a discount. Inflation compoliates things long term, but what if you churned the investments, realising any gains sooner than later? I wonder if a savvy investor could even be better off?

Paul

November 23, 2018

So, for a share investor using a margin loan, interest expenses relating to stocks held in the portfolio up until the date of the new legislation can be offset against salary/wage income (grandfathered) but any new share acquisitions into the same portfolio (same margin loan account) post the introduction of the new legislation would be subject to different tax treatment? Seems like an administrative nightmare and completely unworkable.

davidy

November 22, 2018

So really it becomes a question of when the tax deduction is allowed - now it's used against current income (wages, other) but under Labor the deduction is deferred until the sale of the property/shares or against positive geared income ??

I would really like to see some worked examples but hey this seems to hard for Labor and their experts.

bob deutsch

November 22, 2018

If Labor is elected, there will be a lot more complex legislation - think negative gearing restrictions, denial of excess imputation credits with carve outs for age pensioners and SMSFs with age pension members as at 28 March 2018, minimum tax of 30% on distributions out of discretionary trusts just to mention a few.

Bob

Sarah Butterworth

November 22, 2018

I have a couple of questions please:
Does the "full grandfathering" of existing negatively geared property imply that the losses can continue to be offset against wages/salary or is this to change to be limited to investment income? and
Is a director's dividend payment (sole director) classed as investment earnings or salary for Labor's purposes?
thank you

Bob Deutsch

November 22, 2018

I think it means losses on grandfathered properties can continue to be offset against wages but it will depend on the legislative detail.

Bob

Stephen

November 24, 2018

Sarah,

Dividend payments are investment income but directors fees are personal income. I don't imagine this will change under Labor as they have stood the test of time.

Bruce Bennett

November 22, 2018

If the dividends from Raylene's shares were franked, would the franking credits form part of her total investment income?

bobdeutsch

November 22, 2018

A good question but I think logically the total of her grossed-up dividend is her total investment income. It will depend on the detail in the legislation

Bob

Hank

November 22, 2018

more complexity in taxation .... just what this country needs!


 

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