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
= “Why negative gearing is here to stay…”] Once again the idea of changing the tax benefits afforded to investors via negative gearing has been floated in the context of broader tax reform.
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.
The real or opportunity cost
As anyone knows we can’t have it all, there are trade-offs with any choice we make.
The real or opportunity cost of any choice is the value of the alternative forgone.
It’s true on a societal level and a personal one. We face limitations, both with our time and money.
Budget constraints force us to make choices about how we spend the limited income we have at our disposal. After we have paid taxes, we allocate our income and either spend it or save it.
If we can save, we can then choose what to do with the savings, but
an individual’s evaluation
of the allocation of their funds is
will depend on their
Do you remember when your parent used to say “because I said so!”? You knew there was more to the story, but you knew they just didn’t have the time or energy or will to explain why!
Take the now-defunct carbon tax as an example. Observing the debate it seemed to me that politicians typically lack sufficient skills to convince any kid they need to eat their greens, let alone the voting public that it needs to pay more for the things they buy!
Pollution is a negative externality; an undesirable by-product of another productive activity and is an example of market failure. It’s widely understood that the factors of production involved in producing an item determine its cost. What most people are not conscious of is the hidden costs, those that aren’t obvious, the costs that we all bear whether we buy the product or not. The most obvious example being pollution.
Price is a rationing device and the only way to make consumers bear the actual cost of a product, and perhaps change their consumption patterns, is to internalize or price the hidden costs, in other words, make them pay for it.
For those who have teenage children, how many times have you caught yourself saying things like, “wait till you’re paying the bills, then you’ll switch off the lights”!
That’s because they don’t yet bear the cost, their usage of your electricity is not priced; it’s not internalized.
But at the same time, I do feel sorry for policymakers because there are no easy answers. Opportunity cost, the alternative foregone is never more apparent than when looking at the competing claims on the budget. Every budget decision means that some other wish has to be crossed off the list or at best trimmed back. There is also the unintended trade-offs that come with policy decisions.
Ever been to a dinner party or BBQ where someone pronounces with the enormous certainty that ignorance allows, “the government should just….”?
Similarly, those that claim housing affordability will be magically fixed by changing the tax rules around negative gearing don’t seem to have any inkling (or alternative suggestions for that matter) about how the public sector would provide all that rental accommodation in the absence of investor activity. They have even less appreciation of the private vs public efficiency trade-off or the likely effect on rent of an investor exodus from the housing market. One politician recently responded to the suggestion by saying “oh, it’s complicated”. Really?! They should be able to do better than that! They could:
Explain that tax breaks for investors encourage the supply of housing in an already constrained market more cost-effectively than the public sector could ever do and that it encourages a rapidly aging population to invest for the future and reduce the burden on the future public purse.
Explain that housing starts are a leading indicator of economic activity and therefore, jobs and the multiplier effect of house construction is huge. Building new properties has a ripple effect on consumption that is hard to replicate.
Explain that the new driver of growth and therefore jobs are population growth and the houses and infrastructure and services they will demand, all 32,000,000 of us by 2033. That’s less than 13 years from now! Incentivizing the simple ‘changing of hands’ in the property investment market may be a lot less socially beneficial than encouraging new construction.
But then things are never that simple….