– G Right or wrong?

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You’ve bought your home and now you want an investment property. So, do what millions have done before you – borrow the money, buy an apartment and write off the interest against your tax. In this special series we debate whether so-called negative gearing is wrong.

When young people leave home, they rent. When they find partners, they buy. And when their children leave home, they buy something to rent out.

Where home ownership was once the great Australian dream, a negatively geared rental property has become for many in the baby-boomer generation the next step in the pattern of life.

Governments of all political persuasions have encouraged them with generous tax concessions to provide adequately for retirement, and while some landlords look for long-term income streams, others hope for big capital gains to bolster their superannuation stockpiles.

But are they doing their country a great favour or a huge disservice? Has their money kept the building industry buoyant and the rental market in check or has it just added to an unproductive property price bubble?

Most importantly, would their dollars be better invested in more productive industries?

High-profile Liberal backbencher Malcolm Turnbull has reopened the debate with his proposals for tax reform that would ultimately reduce marginal tax rates so that even the highest income earners would pay tax at the same rate as corporations.

The argument follows that high and middle-income earners have more to gain from negative gearing when income tax rates and interest rates are high, and especially so when property prices rise faster than inflation.

Lower tax rates would make property investment less attractive, and if that reduced the scramble to buy places to rent out, there would be no property price bubbles.

Nearly 1.5 million taxpayers — about 17 per cent of the workforce — make claims for rental deductions, and until the property boom came off the boil last year, the numbers were growing like topsy.

According to the latest Tax Office figures, they claimed deductions of $17.8 billion in the tax year to June 2004, which was $2.6 billion more than they collected in rent.

The ever widening gap between rental deductions (up 19.5 per cent) and rental income (up 12 per cent) was enough for the Tax Office to warn landlords that they would be on the lookout this year for improperly claimed deductions.

Peter Abelson, economics professor at Macquarie University, says Turnbull’s call for tax reform makes sense because high marginal tax rates encourage tax minimisation through corporate structures or superannuation schemes that defer income.

“People play financial games that are just not productive. If marginal tax is reduced, bringing personal income tax down to the level of corporate rates, people will invest in more productive ways. There will be a tendency to reduce negative gearing as part of their financial strategies.”

Some have seen negative gearing as a rort but spiralling house prices and rents that followed its abolition in the mid-1980s forced the Hawke government to reinstate it within two years.

More than a decade later, the Howard Government opened the door wider by allowing capital gains to be discounted by 50 per cent before applying tax at marginal income tax rates.

The move was designed to improve Australia’s competitiveness by promoting investment in high-growth companies but it applied to all forms of investments and led to a boom in inner-city apartment development, especially in places such as Melbourne’s Docklands.

As soon as the discount kicked in, Australia’s landlords collectively moved into negative territory. In the 2000-01 tax year, claims for deductions exceeded rents collected by $770 million. In 2002-03 the figure had almost doubled to $1.36 billion, and it nearly doubled again in the 2003-04 tax year to $2.6 billion. However, the tax collected on capital gains has also increased. It jumped $300 million in 1999-2000, rose another $43 million in 2000-01 and a further $248 million in 2001-02 before settling back to a $7 million increase in 2002-03. The figures, however, do not differentiate between the capital gains on properties and other investments.

The Reserve Bank, which claims the federal tax rules have encouraged speculation in the housing market, says Australian landlords receive more generous tax treatment than counterparts overseas.

In its statement to the Productivity Commission two years ago, the RBA said: “In most countries the earning of rental income is seen as the most important reason for investing in rental properties. This seems to stand in contrast to the situation in Australia, where properties are commonly marketed on the assumption that they do not earn positive taxable income for a considerable period.”

The commission’s report in November 2003 published details of overseas tax arrangements on home ownership that would indicate that the Australian system is both unique and generous.

Australian owner-occupiers pay no tax on imputed rent or capital gains tax on their homes but neither do they get deductions on their interest.

Australian landlords, on the other hand, are allowed to claim deductions for interest paid on borrowings, cash paid on services and maintenance, depreciation on fixtures and fittings, and capital works at 2.5 per cent of original construction costs. And when they sell their rental properties, the pre-tax capital gain is discounted 50 per cent or 33 per cent in the case of superannuation funds.

The discounted capital gain is then added to income in the year the property is sold and taxed at the applicable income tax rate. There are advantages here for people who sell in the year they leave the workforce or if they can defer the tax to a year of low income or, better still for them, when tax-effective superannuation arrangements kick in.

Japan is the only other OECD country that makes similar allowances on rental properties but the Japanese have the added burden of a capital gains tax on their homes.

New Zealand landlords are allowed to gear their properties negatively but the capital gains tax discount is limited to a clawback on depreciation. New Zealanders do not pay stamp duty on property.

Negative gearing is permitted but on a restricted basis in Canada, France and Germany. In about half of Canada’s provinces, there is no stamp duty.

The toughest regimes appear to be Britain and Sweden. In Britain, there is no negative gearing or depreciation allowances on rental properties and landlords must pay capital gains tax.

In Sweden, negative gearing is restricted and there are no discounts on the capital gains tax on rental properties. In addition, Swedish owner-occupiers have to pay both capital gains tax and tax on the imputed rent of their homes.

The US, however, gets it all. There is no imputed rent on owner-occupiers or capital gains tax after two years’ residence. In addition, home owners get interest deductions. They pay capital gains tax on rental properties but enjoy restricted negative gearing with depreciation allowances, and there is no stamp duty.

Cameron Rider, professor of taxation at Melbourne University, is one of the most vocal critics of Australia’s negative gearing system, claiming investors get a great big free kick that fails even the most limited test of tax equity.

He says those who are buying a second house do so at the expense of those who are still trying to save sufficient income to acquire their first house.

In a joint submission to a Senate inquiry into the structure and distributive effects of the tax system, Professor Rider and Melbourne University senior lecturer Miranda Stewart said that first home buyers paid twice as much in after-tax interest costs as investors enjoying the benefits of negative gearing concessions.

“One might think it difficult to find any sensible policy basis for allowing a different treatment to apply for passive property investment where gains from investment property are taxed at normal rates. Where such gains are, in fact, taxed at half the normal rate, as is now the case in Australia, it might be thought impossible.”

They suggested that at the very least first home buyers should be allowed a deduction or a tax offset on their interest to help them compete on a level playing field.

Better still, they argued for a tighter regime of deductions on net interest over rent. They suggested the annual deduction be reduced to 50 per cent, with the remaining half deducted from the capital gains tax after the sale of a property.

The Productivity Commission found that the changes in 1999 that allowed the 50 per cent discount on the capital gain contributed to a surge in investment in rental housing and added to price pressures.

The Government rejected its call for a review of the tax arrangements, especially capital gains tax provisions that had contributed to excessive investment in rental housing.

The Senate’s all party economics committee, which this month asked the Government to think again, said: “Reviewing the capital gains tax provisions offers one of the few realistic alternatives available for moderating the excessive demand for investment housing, a significant distortion in the housing market.”

Turnbull says the bubble effect is part economic and part psychological, adding that the boom-bust cycle is not desirable in any market, “least of all when we are dealing with most Australian families’ principal asset”.

Since the Productivity Commission looked at the impact of the rental market on first home ownership, property prices have stabilised and, in the case of inner-city home units, they have dipped.

The Housing Industry Association says the fall in rental investment is a worrying trend that could lead to zero vacancy rates and rent rises by the end of next year.

Angie Zigomanis, property analyst at BIS Shrapnel, says the slowdown in the rental property market is already having an effect on rents, especially in Sydney. The stockpile of available rental property has dried up quickly and high vacancy rates have disappeared.

“The market has slowed down because prices went high and rental yields dropped back dramatically. People found they were shelling out too much from their own pocket.

“Anyone who bought in 12 months ago is sitting on a loss after paying all their expenses, and they are not going to make a profit for some time.”

He says that people who have paid deposits on off-the-plan developments can expect to wait up to three years before they take possession, which means the rental market will remain tight.

By that time he expects a rise in rents that will once again make property investments worthwhile and give rise to the possibility of the price hike cycle beginning all over again.

“Money is a currency, like electricity and it requires momentum to make it Effective”
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