Negative gearing: what practical effect does it have and should it be changed?

It occurred to me that while most people seem to have an opinion on the negative gearing debate (usually based upon their current status as a landlord, homeowner or renter, which is natural enough) few seem have a grasp of what the numbers involved might look like for an individual taxpayer.

In fact, when numbers are involved in almost any debate the eyes of a fair percentage of people slowly glaze over before you are met with a blank stare, and, if you are particularly unfortunate, some drool. Below are some actual examples (I've rounded off the numbers for the sake of simplicity).

1 - Positive gearing - large deposit

Although property gurus try to sell the idea that positively geared property - where the rental income covers all costs of ownership - is somehow mystical and complicated, it's actually a simple concept which is often largely related to how a deal is financed. An institutional residential fund might undertake a major renovation or subdivision and renegotiate leases in order to achieve the outcome, but there are much simpler ways in which a private investor might secure a positively geared property.

One is to use a very large deposit. Here are is an actual example of a $200,000 regional one-bedroom unit which generates a 6.25% rental yield. The purchaser uses a sizeable 50% deposit and an interest only mortgage fixed at a rate of 5%, and thus receives an income each year.

Rental income - 6.25% yield                     $12,500

Mortgage - interest only at 5%                 $(5,000)

Repairs, management, strata fees etc    $(3,250)

Net cash flow per annum                             $4,250

The main downside to this approach is that the landlord needs a very large deposit (when the use of leverage is diminished so too are the projected returns, and thus residential property becomes considerably less appealing as an investment).

Further, regional properties have historically achieved significantly lower capital growth rates, which accounts for the higher percentage rental yield. Yes, of course, over any given time period capital growth might be solid, but over the long term capital growth rates tend to be highest where the demand is strongest, a real estate trend that is easy to witness all over the globe.

2 - Positive gearing - cheap cost of capital

When mortgages rates are cheap then it's also easily possible to positively gear property. Here's a property bought for £200,000, a 1 bedroom flat in London using a 25% deposit and which generates a 5.2% yield. Mortgage rates are very cheap in Britain and therefore the net cash flow before tax in this example is instantly positive, even before any allowances which might be claimable on furnished properties.

Rental income - 5.2% yield                                   £10,400

Mortgage - interest only @ 3.5%                       £(6,125)

Repairs, management, service charge etc     £(3,000)

Net cash flow before tax per annum                 £1,275

3- Positive cash flow in Australia

In Australia, we have the so-termed negative gearing tax legislation whereby certain losses on investment property can be offset against other forms of income on an individual's tax return. In some circumstances this can turn a cash flow loss into am effective positive cash flow after depreciation allowances and associated tax savings are factored in.

Let's use the regional one-bedroom unit property in example one again, but this time the buyer has only used a 10% deposit and has claimed depreciation allowances on the property of $2,000. The mortgage remains an interest only product at a rate of 5%.

Rental income - 6.25% yield                     $12,500

Mortgage - interest only at 5%                 $(9,500)

Repairs, management, strata fees etc    $(3,250)

Net cash flow per annum                             $(250)

Add back allowances                                     $(2,000)

Loss on tax return                                          $(2,250)

Tax saving at 37% marginal rate              $833

Cash flow after tax                                          $533

In this instance, the depreciation allowance and the prevailing tax rules have turned a small net loss into a small positive cash flow, assuming that the taxpayer is paying PAYG income tax at the 37% marginal rate (I've disregarded the 1.5% Medicare levy here).

4 - Negatively geared property

OK, so onto an example of a typical negatively geared property as things stand today. In this example, a higher rate taxpayer has bought a $650,000, two-bedroom capital city property, which generates a 5% yield, using a 10% deposit. The mortgage is once again interest only at 5%.

Rental income - 5% yield                                $32,500

Mortgage - interest only at 5%                     $(29,250)

Repairs, management, strata fees etc       $(10,000)

Net cash flow per annum                                $(6,750)

Add back depreciation                                    $(3,000)

Loss on tax return                                             $(9,750)

Tax saving at 45% marginal rate                  $4,388

Cash flow after tax                                              $(2,363)

5 - Malinvestment?

So, what's the big deal, you may ask? In the example above, the taxpayer made a net cash flow loss - although not a chronic one - and saved a bit of tax. So what?

Well, one issue is that we currently have a cash rate of 2.50% which is sitting at around 50 year lows. What happens if mortgage rates are at, say, 10%, and a higher rate taxpayer buys an expensive property which generates only a low yield, predominantly for the purposes of saving tax?

This is not an actual example, so we can perm any numbers we like here. But let's use this example of a $1 million apartment property which generates a weak 3% rental yield, has high other strata and holding costs and only has a small amount of depreciation claimable. It's financed at some time in the future using an 10% deposit and an interest only mortgage at a rate of, say, 10% per annum.

Rental income - 3% yield                               $30,000

Mortgage - interest only at 10%                 $(90,000)

Repairs, management, strata fees etc       $(20,000)

Net cash flow per annum                                $(80,000)

Add back depreciation                                     $(2,000)

Loss on tax return                                              $(82,000)

Tax saving at 45% marginal rate                   $(36,900)

Cash flow after tax                                              $(43,100)

Arguably the landlord is making this purchase largely for the purposes of saving tax, for without the negative gearing rulings the property would generate a huge annual cash flow loss, as much as $80,000 in year one. Although the property will generate a positive cash flow eventually (as rental income tends to increase over time in an inflationary economy) this could take many, many years to eventuate and thus the owner is largely speculating on capital gains rather than the growing income stream.

Will negative gearing tax legislation be abolished?

The debate rumbles on, with both sides tending to highlight the issues which suit their own side of the argument. When the rules were amended and losses quarantined in 1985 for a short period of time, the REIA argues that "rents rose 37% across Australia and 57% in Sydney".

Those in favour of scrapping the legislation retort that if you deflate rental increases by the CPI (inflation) rate then the increases were only real and significant in Sydney and Perth. A fair point, although the 'basket' of CPI goods itself includes rental costs, so to some extent that could be something of a circular argument. In any case, renters don't adjust rent increases (or the cost of anything else for that matter) for CPI; they simply look at their actual rent payments.

What happened in 1985 is less relevant than might happen today if losses were once again quarantined. Intuition tells me that landlords would use the shift to the new environment as an excuse to attempt to jack up rents immediately. Whether or not they would be successful in so doing is harder to judge. Common sense dictates that the odds of 'success' for the landlord would be higher where rental vacancy rates are low, such as in certain middle-ring Sydney suburbs or in Darwin, and lower where there is an over-supply of stock such as in Melbourne's Docklands or in a number of regional areas.

We should also be wary of trying to rewrite history. Read books which touch on the subject written in the first half of the 1990s and the increase in Sydney and Perth rents is only cited as a secondary reason for the reinstatement of the negative gearing rules. The principal reason cited was a jump in housing waiting lists (in New South Wales the numbers increased "from under $110,000 to above $140,000" during the period for which the rules were changed, a worrying "trend which was immediately reversed" upon their reinstatement.

It's also possibly an over-simplification to say that governments will simply save dollars by scrapping the existing rules. I believe his numbers on housing lists may be inaccurate ("the waiting lists for public housing increased by 50% in 1985") but tax accountant Ed Chan highlights why he believes government costs and impacts on the wider economy would escalate if more public housing was required in this article here.

Conclusion

Clearly from 1987 to date the government has steered away from the risk of crashing the housing market (and the Aussie economy?) by again altering the tax legislation, but that does not mean that it will never do so. Personally, I think it's unrealistic to expect that the rules will be amended in one fell swoop due to the potentially destabilising effect: it's hard to envisage risk-averse politicians taking that chance.

The most sensible viewpoints I've heard are from property expert Catherine Cashmore, who suggests that the existing rules might be slowly unpicked while other strategies are implemented to attack Australia's supply-side issues - take a read here. There are a number of ways in which this might be kick-started - one might be to limit the number of properties which a landlord can claim losses on.

"I have no doubt if the policy were removed, or even scaled down, there would be less demand for established stock and a subsequent dampening in prices.  I agree that a sudden and complete retraction of negative gearing in its current form would be foolish - favouring a slow wind-down whilst other policies are implemented such as strategies to aid development and increase supply."

While landlords often seem to want property prices to grow to the sky and renters want to see an instantaneous property crash, neither of these outcomes is desirable for our wider society or for our economy. Far better, in my opinion at least, would be a prolonged period of moderate property price growth which is somewhat slower than the rate of household income growth (thus making real prices more affordable over time). The problem facing us is that humans are irrational beings and thus tend towards boom and bust, but that doesn't mean that we shouldn't try.

His new book 'Four Green Houses and a Red Hotel' is out now.