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Time and tide should dampen negative gearing proposal

In 1027, King Canute stood by the seashore and commanded the incoming tide to halt. Of course, the tide ignored him and he ended up with wet feet. As legend has it, he leapt backwards, saying: “Let all men know how empty and worthless is the power of kings.” Contrary to the common myth, the wise king was not showing off – he was demonstrating to his subjects the limit of his power.

Canute’s order to the sea is an analogy for the Labor Party’s attempt to make housing more affordable for first home buyers. It simply can't be done. It's ironic that the catalyst for the GFC was President Clinton's idea that housing should be available to everybody. It started with a boom as the American property market became overbuilt, with loans offered to everybody irrespective of ability to pay. It finished with a bust whose reverberations are still being felt around the world.

Australia faces a perfect storm

But the GFC was more than a bust. It triggered collapses in stock markets everywhere, with interest rates around the world falling to historically low levels as central banks try to stimulate their economies.

Australia was not immune, but what has become different here is the growing attack on our superannuation system by politicians and so-called independent think tanks.

So we face the perfect storm. The average Aussie investor has lost faith in the stock market, and they are scared off superannuation because of the adverse publicity and threatened changes. They also know that earning a piddling 2% in the bank isn't the way to go long term.

Consequently, they have invested in the property market. As interest rates fell, making mortgages more affordable, prices started to rise. As always happens, the moment any asset class starts to rise in value, everybody wants to jump on the bandwagon. Yes, that made it tougher for first home buyers, but historically every initiative by governments to make housing more affordable has simply raised home prices further, because more buyers are attracted to the market. Think of the first home owners grant and stamp duty concessions.

On new property, the developer has made the profit

Labor’s policy of restricting negative gearing to new homes won't work. It will push unsophisticated investors into new property where the profit has already been made by the developer, leaving the established market for more savvy investors. They understand that the way to make money in real estate is to buy a rundown property on a good block and add value to it. The irony is that they will use the money they can no longer contribute to superannuation as a deposit. This may make the property positively geared from the outset.

Let me quote a case study from Philip, who sent this to me in the interests of a more rational debate about negative gearing.

“I purchased an apartment in October 1987, borrowing 100% of the purchase price using my residence as security. The taxable loss was $7000 a year so my tax refund was in the order of $3,000 p.a. Three years later I paid it off when rates hit 17%. Total tax saved over those three years was around $10,000. After paying off the loan it was positively geared and I was paying $2000 in tax on the net rents.

The property has been positively geared for the last 25 years. Current net rent is $6,000 p.a. and at my marginal tax rate of 32.5% my tax is around $2,000 p.a. So having gained a net tax benefit of approximately $10,000 in the late 80's, I have paid $50,000 in tax since.

The value of the property has risen substantially from my purchase price of $58,500 to a current value of $320,000. But when I sell I will be liable for capital gains tax of $30,000.

Since 1987 I have enjoyed net tax refunds of approximately $10,000 but have subsequently paid $50,000 in income tax and will shortly pay another $30,000 in CGT. The government has made a significant net $70,000 benefit from my investment risk and the subsequent good capital growth will almost certainly eliminate my ability to claim a pension in retirement. This sounds like a great deal for the Government to me.”

Limiting negative gearing will be as successful a policy as was holding back the tide for a wet King Canute.

 

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. See www.noelwhittaker.com

 

9 Comments
Graeme
July 08, 2016

I would probably put Dr Hewson's views in the same basket as those of all the 'trickle down' economics proponents. Sounded good in theory, three decades later it has yet to happen. Unfortunately, human nature what it is, one of the dominant animal spirits is greed.

Peter Knight
July 22, 2016

Well it's happening in New Zealand Graeme and they don't have too much of a problem with their economy. I recently read an article about an Aussie truck driver who moved to Methven NZ after the GFC and he got a job straight away driving a truck. His wife said that housing, both rental and purchase, was much cheaper than Oz. The government has just CUT (2016) the cost of car registration and ALL other taxes are less than in OZ. Sounds like it's trickled down over there Graeme. It just proves to me that if the government plays its part in reducing taxes then people will benefit in all sorts of ways. NZ doesn't have any CGT and has a much lower top MTR than OZ. So everything Graeme above has said, has shown and is still being shown, to be not valid! I think I'll believe Dr Hewson's qualifications over Graeme's any day!

Peter Knight
July 01, 2016

Twenty five percent flat tax rate with no deductions would be ideal. Hewson proposed a 15% GST which again would be ideal. Your concern about the low paid people is not justified because as always, they are taken care of by the tax transfer system. This would mean that they couldn't be worse off as a result of these changes. Genuine people would be protected, entrepreneurial people's animal spirits would be unleashed, pensioners would have significantly increased pension payments and thousands of accountants would have to re-invent themselves into more productive activities instead of managing taxation issues and deductions for companies and individuals. Are you suggesting Graeme, that Dr Hewson doesn't know what he's talking about?

Graeme
June 30, 2016

What would you suggest the flat rate of tax be? Have to be less than 10% or those on the basic wage of $34158 will be paying more than they currently do. Not to mention those who can only get part time low paid work who will now have to start paying pay tax. Then to compensate for the blow out in the deficit we hike the GST rate which will slug the lower paid even more.

Fortunately the vast majority of Australians, as well as most (all?) the countries in the world see the desirability of a progressive tax system.

Peter Knight
June 30, 2016

Negative Gearing is and should remain a legitimate tool in a high taxing nation. Judging by the commentary in this segment, no one seems to realise that if personal MTR's are too high then negative gearing will prevail. If everyone paid a flat rate of tax which was NO higher than the corporate tax rate, then Negative Gearing wouldn't be a viable investment option. The only people being greedy are the politicians not the investors! Low MTR's with a commensurate consumption tax rate of whatever is required to provide existing revenue, would fix the problem overnight. I include in this that no deductions can be claimed, further reducing the tax loss to the Government. Funny enough this plan was going to be introduced back in 1993 by John Hewson. The dopey electorate rejected that plan then and the dopey electorate still don't get what's going on. It's not Phillip that's gaming the system, it's the greedy governments taxing us all into oblivion. BTW all this is happening whilst the TRULY SUPER RICH-people like the PM live in totally Tax Free residences worth in his case, up to $70 Million! Believe me, Phillip is NOT the problem it is the Pollies; as is always the case!

Craig
June 27, 2016

The strategy I've seen is this, and problem is not everyone obeys the rules:

You buy a house on some land which is geared as much as possible. You then build a granny flat on the same land. The house is rented out and the loss reduces the tax payable on your personal income. The granny flat is also rented, but for cash so that it is "off the books". (Editor note: don't know how anyone can claim a deduction when there is no income against it. Not only illegal not to declare income but ATO could easily spot deductions with no income).

Once you've done this half a dozen times or so, you have a stack of property that wipes out your tax bill on your personal income - and a cash income from half a dozen granny flats that pay your living expenses. Yes it's illegal, but that's how some people are using negative gearing to commit tax fraud while competing against others who have to pay tax, and rent, while trying to save for their own home. (Editor note: We'll accept this as a comment in the debate but obviously we do not condone this strategy).

BB
June 24, 2016

"The govt made $70,000 on my investment risk" Really, the fact the investor believes that it was simply his investment risk that contributed to the total gains (and taxes) is the larger part of the problem here! Not to mention that acquiring wealth that eliminates pension eligibility is somehow a negative? The mentality we have fostered in this country is unbelievable.

No Philip, assuming no significant valuation uplift from value add, your gain was generated by restrictive land planning, federal govt incentives, financial deregulation, gentrification of the area and huge national population growth. None of which you controlled nor directly paid for since 1987.

And Noel, a practical example for today's market and regulatory environment = a war story from a cashed up property investor in 1987.

Alan
June 24, 2016

Totally agree Graeme - I would love to buy some investment properties but cannot compete with people able to negatively gear and use larger tax refunds to fund their purchase. I would have to pay the same CGT when selling but because I am not getting a tax refund at the earned income rate my running costs are far higher.

Graeme
June 23, 2016

In the case study, all the revenue cost to the government was in the first three years. Phillip then paid back the loan. By the way, this is not positive gearing, it is nil gearing. From then on he paid tax on the net rental income. Hence all the income revenue the government received was when the property had nil gearing.

As Phillip was able to repay the whole loan in the third year, one can conjecture that he did not need to borrow 100% in the first place and only did so to maximise the tax deduction. Meanwhile the person who wanted to buy the house to live in could not compete against tax assisted Phillip. Perhaps that person then had to rent Phillip's extra house!

While obviously not your intent, this is an excellent example of why negative gearing should be limited. Whether it will work is unfortunately another question. It may not be possible to hold back the 'tide' of banks, real estate agents and advisers whose profits depend on everyone borrowing as much money as possible and the resulting highest possible housing prices.

 

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