Gearing is borrowing
to buy an asset
with a small personal contribution and
borrowing the rest from others
Property investors aim to earn income from the property in the form of rent in the short term and a capital gain, long term.
Property investment is negatively geared when the rental income doesn’t cover all the costs associated with owning the property.
The Australian Tax Office allows property investors to reduce their taxable income by the amount of the shortfall.
It is also important to note that property can be positively geared, where the income received exceeds the holding costs. Neutrally geared property exists where after all income and expenses are calculated, the property ‘breaks even’, that is the rent covers the expenses but no more.
Any property can be positively or neutrally geared depending on the LVR and the size of the investor’s contribution.
Typically though the idea of a positively geared property relates to the concept of the rent exceeding the holding costs with only a minimum deposit, this is more likely in rural areas where prices are low and rents typically much higher relative to the purchase price. The trade-off may be lower capital growth long term.
Why negative gearing is here to stay
Australia is a market economy and, in a perfect world, freely operating markets are efficient and deliver maximum satisfaction for all. But it isn’t an ideal world. Sometimes market solutions are inadequate, inequitable and lacking in social responsibility- you only have to look at the causes of the GFC to see a classic example!!
There is a role for government to redistribute income and resources in ways that enhance market solutions and compensate for market failure.
Tax benefits for negatively geared investment property are a perfect example of government policy designed to achieve a desirable market outcome. The government provides tax incentives for individuals to invest in property, especially new property, thereby increasing the stock of available housing and delivering significant employment opportunities as a byproduct. The stimulus to private sector property investment through tax concessions helps to redress the housing imbalance and reduces pressure in the rental market.
It also importantly promotes entrepreneurial spirit, the building block of the market system, and is an incentive for individuals to create wealth for their retirements, thereby reducing the burden on future generations. Shifting the goalposts to be eligible for the age pension to 67 after 2023 is in direct response to the looming crisis in the economy’s ability to support an aging population that no longer contributes to the public purse.
We all need to become proactive now so that we don’t end up reliant on the overstretched welfare system in the future. It is also essential to understand why tax benefits are maximized on a new property through depreciation.
Depreciation means that you are allowed to claim a proportion of your property’s value, the building and its fixtures and fittings, for wear and tear over time as another cost of ownership. This claim is most substantial in the early years of a property’s life and so building a new property is the best way to take advantage of the ATO’s concessions.
A healthy building industry is vital for economic growth and employment. The multiplier effect of construction means not only work for tradespeople and suppliers, but it has a ripple effect on the retail industry for white goods, carpets, blinds, turf, fencers, landscapers, moving companies, and the list goes on! No wonder the government considers ‘housing starts’ a leading economic indicator.
Policy changes involve trade-offs and disincentive effects, both intended and unintended. Removing tax advantages for property investment would reduce the supply of housing and put the onus back on the public sector to provide more public housing.