The Taxman’s Terrible Treat 

The Australian taxation system is very generous to property investors. They can write off real estate losses stemming from expenses being higher than rent, in effect lowering or even eliminating their annual income tax obligation. In many instances, they qualify for a 50% capital gains tax (CGT) discount too! Ice cream and topping! Bonus!

A cosy relationship exists between tax concessions and property price growth, as evidenced by this fact: since the Howard-Costello government changed the capital gains tax regime in 1999 (from cost base indexation to a 50 percent CGT discount) the median house price in Sydney has increased 258 percent, from $280,000 to $1,004,800 (Source: REIA). Sugar rush!

Even accounting for inflation and low interest rates, this is a stunning price increase never before seen in the history of post WWII Australian real estate – possibly ever.

It’s fair to conclude that tax concessions, favourable to the point of being gratuitous, stimulate demand and help to ensure property prices remain inflated. At the same time, by promoting robust investor appetite for real estate and hence mortgages, they put a secure floor under the security, viability and profitability of our big banks,.

Be that as it may, another quirk of our taxation regime is more widely known, used, and frankly, abused, than those coveted concessions previously discussed. It’s the ability to refinance capital gains – tax free, better known as, ‘you won’t pay tax (CGT) if you don’t sell.’ Ice-cream and topping and nuts!

Tax Deferred Is Not Tax Saved

Under Australian taxation law, a capital gain is triggered when an asset is disposed. Accessing a portion of capital appreciation or equity via a loan is not a disposal.

Hence property investors can happily tap their equity today (when they refinance) and pay tax tomorrow (when they sell) to their heart’s content.

It would be interesting for Treasury to estimate the amount of taxation being deferred by investors refinancing rather than realising their capital gains.

This perfectly legal tax dodge must be costing the Federal Government many billions of precious taxation bucks at a time when they have an urgent need for more money. (In case you haven’t heard, the budget deficit you keep hearing about indicates we are spending more than we are earning and having to borrow the shortfall).

But tax deferral via refinancing equity is not the so-called free lunch that it is so often made to be. Yes, in the hands of a skilled and experienced investor the extra leverage can be powerful, but in the hands of the ignorant, the novice, or the speculator, it’s a dangerous trap that can can turn deadly in a property downturn.

Property Values Are Variable, Debt Values Are Fixed. Provided Values Rise, The Investor Will Be A Winner. If They Fall, Look Out!

In a market correction, evidenced by sudden falls in value, it is entirely possible for a property’s value to fall below the amount of its loan. This can be especially true if aggressive debt has been used for the purchase of the property (such as a greater than 80 percent LVR first mortgage); and even more so if the property’s equity has been subsequently tapped, either via an increase in the first mortgage or using a line of credit or similar loan.

Who Else Wants A Zero Percent Loan?

Being able to refinance your equity and defer your income tax on unrealised capital gains adds further hot air and serves to keep the property bubble happily afloat.

In effect, the government gives investors a zero percent loan on the payment of that future CGT tax obligation. At the same time, the government unavoidably acquires a vested interest in keeping property prices high, because the deferred tax loan is contingent upon that property’s price not falling (in which case the tax deferred tax liability falls too). Woe to us if the government spends the deferred tax money it is yet to collect today and there is a property downturn tomorrow.

The end result is what we have – a feedback loop of acquisition, capital appreciation, refinancing, deferred taxation, then back to acquisition, capital appreciation, etc. This is a game of doubling down, it’s success dependent on the core (flawed) assumption that property prices will keep rising and rising. They don’t; just ask the folks in Japan, Vietnam, US, UK, Greece, etc.

Yet like a game of musical chairs, sooner or later, the easy capital gains fun will end and those investors forced to sell will be the big losers. The more property values fall, the fewer the remaining chairs there’ll be and the greater the number of investing losers who experience ‘negative equity’ or an ‘underwater loan’.

Here’s the advice: when refinancing equity, know you are contributing to the investing equivalent of carbon emissions. Your refinance emits a gas that is warming the market to hotter and hotter temperatures.

At best, refinancing your equity is a short-term solution to a lack of cash. If you use it for a purpose that it was not intended for, such as funding a long term investment position, then let this article serve to place you on notice that you’re entertaining a big risk that’s underpinned by an uncontrollable assumption.

The music will stop one day. Are you prepared? Will you get a seat or be out of the game?

Make wise choices.

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.