One of the Australian Labor Party’s (ALP) big election promises in the 2019 federal election was to abolish negative gearing. It would be logical to think that the ALP’s shock election loss in 2019 will serve as a warning for policy makers. That is, banning negative gearing is an unpopular policy. However, I would caution investors against assuming that negative gearing is here to stay.
What is negative gearing?
Negative gearing allows investors to offset property investment losses against other taxable income (such as employment income) to reduce their tax liabilities.
For example, Colin is employed as a lawyer and earns $200,000 pre-tax. Colin’s employer correctly deducts $64,700 of tax. If Colin borrows $1 million to purchase an investment property, he expects to receive approximately $14,000 of rental income after all expenses (management fees, insurance, maintenance, etc.). The bank will charge him approximately $35,000 p.a. in interest. Therefore, the property will lose approximately $21,000 p.a. ($14k less $35k).
Colin will be able to offset that loss against his employment income to reduce his total taxable income to $179,000 ($200k less $21k). This will reduce his annual tax liability to $54,900, which is a saving of $9,800 p.a. As such, the after-tax cost of the property is $11,200 p.a. ($21k less tax saving of $9.8k). This is called a negative gearing benefit.
Why do people negatively gear?
The only reason that you would negatively gear is that you anticipate that the property’s capital growth will eventually dwarf its income losses.
Continuing with Colin’s example above, let’s consider the projected outcome after 20 years. Let’s assume the property continues to lose $11,200 per year which equates to $224,000 in total over 20 years. This assumes the rental income and interest rate do not change for 20 years, which of course is highly unlikely, but for the sake of simplicity, lets continue. If Colin’s investment property appreciated in value by 7% p.a. on average, it will be worth over $3.8 million in 20 years. After capital gains tax, Colin would have accumulated almost $2.2 million of equity in return for losing $224,000 of income. Most would agree that this is a good financial outcome for Colin.
In short, investors use negative gearing on the expectation that the capital returns generated by an investment (often property), will substantially offset any after-tax income losses over time.
Why is negative gearing at risk?
There are three main reasons that I believe that tax benefits (savings) resulting from borrowing to invest in property will not be as substantial as they have been in the past. As such, I would counsel investors to not rely on negative gearing tax benefits when making investment decisions.
Reason 1: Government will probably (eventually) limit negative gearing
The expansion of federal government debt to over $1 trillion dollars means the government must generate more revenue to service and eventually repay this debt. One way to do that is to grow the economy (GDP) which will generate more tax revenue, even if tax rates don’t change. Another way is to raise taxes or limit deductions.
Just over 11% of Australians invest in property (2.2 million people out of 19.8 million adults). However, only about 3.3% of Australians own 2 or more investment properties. Therefore, if the government limited negative gearing to say one property, fewer election votes would be at risk.
I think the more likely outcome would be to introduce a dollar value limit. For example, maybe negative gearing deductions could be limited to $20,000 per year. Any negative gearing losses that exceed $20,000 could be carried forward to reduce the investment’s cost base (i.e. reduce CGT liability). This policy would still allow low and middle income earners to benefit from negative gearing but limit the benefit to higher income earners. I think this is an attractive proposition for any government.
Reason 2: Persistently low interest rates reduce tax savings
Gross property residential rental yields typically range between 2% and 3.5%. After allowing for expenses (such as management fees, maintenance, insurances and so on), net rental yields typically range between 1% and 2.5%. With interest-only investment rates starting at 2.5% p.a. (fixed rates), a property’s pre-tax income loss can range from nil to 1.5% of a property’s value (being net yield less interest rate). This means if your property is worth $1 million, your pre-tax loss probably won’t exceed $15,000 p.a. Consequently, your tax benefit (savings) won’t be more than $,7,050 (being 47% of the loss).
Prior to 2012, variable interest rates exceeded 6% p.a. which meant a property’s pre-tax loss would typically be in the range of 2.5% and 5% of a property’s value. So a $1 million property’s pre-tax loss would therefore range between $25,000 and $50,000 which would save its owner between $12,000 and $23,000 in tax. That’s substantially more than today.
A low interest rate environment greatly reduces negative tax benefits in dollar terms. And if interest rates remain low for an extended period of time, property investors tax savings will be greatly diminished, but then so is their pre-tax cash flow loss.
Reason 3: Stage 3 tax cuts will reduce tax savings
It was reported last week that the ALP will likely support the government’s stage 3 tax cuts which are set to become effective in the 2024/25 financial year. This means that there will only be two tiers for taxpayers that earn in excess of $41,000 p.a.:
- $41,001 to $200,000 = 34.5% tax rate including Medicare; and
- Over $200,001 = 47% tax rate including Medicare.
Currently, the tax rate for earnings between $120,001 and $180,000 attracts a 39% rate of tax. The stage 3 tax cuts benefit taxpayers earning over $120,000, which would include many property investors.
Using Colin’s example at the beginning of this blog, the annual tax savings from investing in property would reduce by almost 40% from $11,200 to $6,900 (because after 2024/25, tax on $200,000 would be $60,000 versus $53,100 on $180,000 of taxable income).
Don’t invest in property (or anything) to save tax
Saving tax alone will never make you independently wealthy. Tax is an unavoidable consequence of building wealth.
Of course, any tax benefits ease the cash flow burden of investing in property. But it is very important that your investment strategy works with or without tax benefits.
To do that you must only invest in investment-grade property/s that has the best capital growth prospects.