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Why abolishing negative gearing makes complete sense

As housing prices plummet in capital cities across Australia, with clearance rates in Melbourne and Sydney slumping to about 50% and prices dropping by 2% in the March quarter, one of Australia’s wealthiest property developers launched a bizarre defence of the negative gearing, the regime that operates to help maintain artificially high property prices.

Eddie Kutner, a former accountant and one of the founders and chairman of Melbourne-based apartment developer Central Equity, wrote an impassioned defence of negative gearing in The Age last week. Central Equity is one of Melbourne’s largest developers, with the Financial Review reporting that it allegedly generated a $59 million profit last year, after being privatised by Kutner and co-founders Dennis Wilson and John Bourke in 2006 for $67.5 million.

Negative gearing” allows investors to use losses from property investments to reduce their overall taxable income. This effectively encourages property buyers to use debt and “bid up” the price of investment property in the hope of a subsequent capital gain. When utilising negative gearing, an investor will take out a substantial loan over a property, such that rental income is less than interest payments and other costs. The strategy is especially effective when the investor is paying the top marginal tax rate of 46%.

Eventually, when the property is finally sold, the investors will hope to make a “capital gain”. Courtesy of various poorly constructed government policy, capital gains are taxed at half the rate of income derived from labour.

Kutner made several claims in defence of negative gearing which appear somewhat illogical.

Kutner initially claimed that “for a short period, from 1986-88, treasurer Paul Keating abolished negative gearing for property investment, but quickly reinstated it when the disastrous impact of this policy on the housing market became obvious”.

This claim is mystifying given the temporary abolition of negative gearing by Keating was not a disaster at all — rather, as former ANZ chief economist Saul Eslake noted, “rents … actually only rose rapidly (at double-digit rates) in Sydney and Perth. And that was because rental vacancy rates were unusually low (in Sydney’s case, barely above 1%) before negative gearing was abolished. In other state capitals (where vacancy rates were higher), growth in rentals was either unchanged or, in Melbourne, actually slowed.”

Kutner then claimed that negative gearing must be a good idea because politicians like it, stating that “surely if negative gearing didn’t have a positive influence on supply (given that it involves a loss of tax revenue), it would be scrapped immediately”. Kutner appears to be confusing sound economic policy with populist vote seeking. Further, other countries don’t appear to share Kutner’s positive views on negative gearing, with the practice not permitted in most countries, including the US and Britain.

But Kutner’s arguments became even more baffling, with the multimillionaire developer claiming that “simply put, were it not for negative gearing, many investors could not afford and would not invest in property. Developments would not have the finance to proceed”.

Of course, the opposite is true.

Negative gearing encourages investors to pay far more for property than its “intrinsic value” (which is determined by the cash profits of an asset over its life, not merely what someone else is willing to pay). This is because the tax benefits of negative gearing compel investors to borrow excessively to purchase a property, so much so, that the yields on residential property are as low as 2% and most investors make a loss on their property investments.

Removing negative gearing would mean investors are not incentivised to borrow such large amounts and instead, investors would limit how much they pay for a property to ensure that they receive a reasonable risk-adjusted yield. This would make property far more affordable — the exact opposite to what Kutner claimed.

Kutner than noted that “if negative gearing were abolished not only would housing supply decrease and prices increase, but the rental market would be decimated. Sometimes 20 or more prospective tenants vie for one property. The rental market needs more properties, not fewer”. As Eslake noted, when negative gearing was removed in the 1980s, rental prices remained steady or actually fell in the majority of Australian cities. Housing supply itself wouldn’t necessarily decrease — however, the profits of builders such as Kutner’s Central Equity would fall and home prices would become far more affordable.

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11 Responses

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  1. twice you mentioned that rents didnt fall in the 1980’s but what was the cost of the average mortgage then - obv rents covered the mortgage outgoings otherwise people would not rent properties out. Now we are in a situation where 1 in 7 Australians own a property they rent out bought at much higher prices there is no doubt that rents will have to rise substantially to cover those much larger mortgages. The reason they dont have this in UK is because rental income covers mortgage income

    by matthew.davies on May 10, 2011 at 2:29 pm

  2. This is a ridiculous article. Any “Investor” worth their salt doesn’t spend (or in the case of this article, borrow) a dollar to get a maximum of 46 cents back. Nobody goes into a property purchase looking to pay as much as they possibly can.

    Blame State Governments for their lack of planning, poor infrastructure and insufficient land releases. They keep the house prices high because they are the ones who make the cash off the stamp duty and other fees on sales.

    Abolishing Negative Gearing would be a great way to hike rents and crash the economy. Property Owners will be faced with a choice, Hike rents or lose money. Faced with being hundreds of dollars a month out of pocket, or making someone else pay, I know what I would do.

    And before anyone says “The tenants will just move on” can someone please tell me where to?

    by abarker on May 10, 2011 at 2:38 pm

  3. Not too sure about this Adam….there’s a lot of your “majority of Australians, young and old”
    who’ve put their hard earned into an investment property rather than the vagaries of the stock market. It’s not just an investment for the wealthy minority….and one reason they did was because of the benefits of negative gearing….

    by Pete from Sydney on May 10, 2011 at 2:43 pm

  4. Not too sure about this Adam….there’s a lot of your “majority of Australians, young and old” who’ve put their hard earned into an investment property rather than the vagaries of the stock market.

    Sadly these people are shortly going to learn a hard lesson about the “vagaries” of a property bubble.

    by drsmithy on May 10, 2011 at 3:48 pm

  5. This is a ridiculous article. Any “Investor” worth their salt doesn’t spend (or in the case of this article, borrow) a dollar to get a maximum of 46 cents back.

    Of course they don’t. They “invest” a dollar based on the speculation that it will be worth two dollars a year or two later when property prices have doubled, which will in turn allow them to borrow another four (or more) dollars (leveraged against their existing property which now has twice its original “value” in equity) in an attempt to repeat the cycle.

    Voila, a property bubble.

    The negative gearing comes in because in Australia’s unique (and broken) system, the cost of all those mortgages is effectively paid for out of what would otherwise be the speculators’ tax bill.

    Abolishing Negative Gearing would be a great way to hike rents and crash the economy. Property Owners will be faced with a choice, Hike rents or lose money. Faced with being hundreds of dollars a month out of pocket, or making someone else pay, I know what I would do.

    The problem is that rents are ultimately based on people’s actual incomes (unlike house prices, which are based on borrowing power).

    You can’t hike rents on tenants who can’t afford to pay more (and make no mistake, lots of tenants - especially in city areas - are right on the edge of how much they can afford), because they pack up and leave.

    And before anyone says “The tenants will just move on” can someone please tell me where to?

    Into one of those properties that will be flooding the market as the property speculators go bankrupt. Into shared houses. Back to their parents. Into the positively-geared properties that real investors own.

    by drsmithy on May 10, 2011 at 3:52 pm

  6. I’d really like a better answer from those saying we should get rid of negative gearing.

    1/ Does this apply only non incorporation taxpayers.
    2/ Does this apply only to one class of asset - ie property used for private housing
    3/ Will this apply to all taxpayers including companies that invest in new or existing assets.

    I agree the housing market is overpriced - but negative gearing is a furphy.

    The issue is manipulated supply - where we no longer release land - and when we do it’s via drip release with limited or zero competition within a new area being released. Landcom, Developers, the Greens and NIMBYs all share responsibility for this.

    The cost of building a house - or renovating has also gone through the roof due to the China Boom and the local Mining Boom - with material and labour costs driven by the global marketplace price for such.

    Getting rid of the first home buyers grant, and restricting loan to equity ratios are another issue.

    by Simon Mansfield on May 10, 2011 at 4:27 pm

  7. Worse still is the availability of negatively geared funds to buy ‘old’ shares. A totally non productive asset Much enjoyed and promoted by banks.

    by Patrick Grant on May 11, 2011 at 8:44 am

  8. What complete twaddle and yet another example of property hysteria.

    There is a very simple accountancy principle at work here which applies everywhere - not just property. ie: Costs expended in earning an income are tax deductable. Clearly removing costs associated with investment property implies that the principle would be applied in a discriminatory fashion. The only people moaning about negative gearing are those who have failed to get into property and who, by promoting abolishing a legitimate tax deduction, fail to understand that the resulting upward pressure on rents would ensure a financial disaster for those families who rent.

    And for those who still do not understand - negative gearing is by definition a self limiting strategy: excess costs above income do need to be funded, therefore for the vast majority of Mum and Dad investors with a property or two, that’s all they will be able to afford. At least they are investing for their retirement, not planning to be a burden on the tax system, and providing a roof over tenants heads.

    A completely stupid and self - serving article.

    by peterd099 on May 11, 2011 at 2:27 pm

  9. There is a very simple accountancy principle at work here which applies everywhere - not just property. ie: Costs expended in earning an income are tax deductable.

    Indeed. However, the nearly unique - and problematic - system in Australia is that the costs expended on earning an income in one place (eg: property) can be deducted from income sourced elsewhere (eg: salary). That is to say, a non-trivial chunk of the “expenses” involved in owning a negatively-geared property are actually coming from the tax the “investor” would normally be paying on their salary.

    In most other tax systems this is not possible (or the extent to which it can be done is severely limited). Expenses can only be deducted from the income those expenses helped to generate. Eg: you would only be able to deduct your property expenses from the rental income that property generated.

    No-one is suggesting the latter be eliminated, only the former.

    The only people moaning about negative gearing are those who have failed to get into property and who, by promoting abolishing a legitimate tax deduction, fail to understand that the resulting upward pressure on rents would ensure a financial disaster for those families who rent.

    Rents cannot rise any higher than the tenants’ ability to pay, which is intrinsically linked to income. Landlords will be faced with two options: accept the rental income they have, or accept no rental income at all.

    And for those who still do not understand - negative gearing is by definition a self limiting strategy: excess costs above income do need to be funded, therefore for the vast majority of Mum and Dad investors with a property or two, that’s all they will be able to afford.

    Sure. The difference is with Australia’s negative gearing system, is they only need to fund a fraction of those costs (proportional to their marginal tax rates) compared to what they would otherwise, because the rest of it is funded by making their income tax bill smaller.

    At least they are investing for their retirement, not planning to be a burden on the tax system, and providing a roof over tenants heads.

    How are they investing for their retirement ? Their properties do not generate income (by definition - in fact they actually *cost* money), and their “wealth” is locked up in an illiquid asset (which is currently overvalued by a ridiculous degree due to a property bubble).

    by drsmithy on May 11, 2011 at 4:31 pm

  10. The negative gearing naysayers also miss another important point: CGT. 50 % of the realised gain on a property is taxed at the marginal rate. Further, Building Depreciation deductions, allowed while the property is held, are clawed back by the ATO as part of the CGT event. So, not quite the bonanza for investors as implied here.

    by peterd099 on May 13, 2011 at 12:54 pm

  11. Fair Go Adam, While I agree with some of the rebuttals of the commentators, in the end t Negative Gearing is nothing but a false economy - and I’m one who “benefits” from it.

    Free money to Construction companies is really all it is as far as I can see.

    You’d think between this and the stimulus the only industry in Australia which need support is the Construction industry.

    Someone has to grow a pair and drop these nonsense tax breaks and simplify things. It should’ve been done when the economy was strong, perhaps, but anytime will do now.

    There will be entitled wailing for a while, but it’ll moderate over time.

    under 3 year election cycles, it’s likely to never happen though.

    by franksting on May 18, 2011 at 10:57 pm

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