In light of the recent revelation that Treasury suppressed documents that showed Labor’s changes to negative gearing would have only a “modest” impact on the housing market — despite the government’s claims to the contrary — Crikey has decided to release this item from the vault. In this piece, originally published on February 18, 2016, economist Jason Murphy explains exactly what negative gearing is, and whether or not it’s a fair model.

Labor wants to change our negative gearing regulations, the Coalition is not so sure. You sure can read a lot about negative gearing without anyone clearly explaining what it is. Let’s fix that.

What is it?

Negative gearing is about having two sources of income: a job and a rental property. But the rental property creates a loss, because the rent doesn’t cover the mortgage. You use the loss to reduce your taxable income.

Example: Salary of $60,000, loss of $10,000 on the rental property; taxable income $50,000.

This would save tax of 32.5% on $10,000 of income, or $3250 less the property owner would have to give to the government.

Negative gearing reduces your tax. It works the same way as giving to charity or buying a uniform for work. You simply deduct your annual property rental loss from your total income.

It is worth repeating: negative gearing doesn’t create free money. It actually requires you to make a loss on your rental property. In the example above, the investor lost $10,000 and saved just $3250 in the tax system.

The biggest discount is for the top tax bracket, members of which pay 49 cents in the dollar, including the Medicare levy and temporary budget repair levy. They would save tax of $4900 on every $10,000 of rental loss but they still lose $5100 after tax. Of course, after enough rental losses they won’t even be in the top tax bracket any more and the benefit shrinks.

If you don’t pay much tax, negative gearing is a bad idea. Nobody should be depending on negative gearing to pay for electricity and tins of sardines.

Average people own investment properties — most people using negative gearing are teachers, etc, as we’ve heard — but they get only a small share of the advantages because of their lower tax rates.

Is it fair?

Housing doesn’t get special treatment. You can negatively gear other investments. You could borrow money at an interest rate of 4%, then put it in a term deposit at 3%. You’d make a loss there and can offset that against your tax. Nobody will complain.

This example is nice because it shows how weird negative gearing properties is. The only reason people do it is because they think the properties will go up in value by more than the annual loss. If you make a loss of $7000 a year after tax, you need the house to appreciate by $7000 per year.

You could try to negatively gear a small sole trader business, but nobody does — nobody expects a loss-making business to rise in value. Housing, clearly, is different.

Negative gearing was introduced by the Bob Hawke-Paul Keating government of the 1980s, amid a fight over rental prices. Now Labor is pledging to mostly undo the changes, which could reap the taxman around $1 billion to $5 billion a year.

What’s capital gains got to do with it?

No discussion of negative gearing can proceed without talking about the other big tax rule for investing: capital gains tax (CGT).

When you sell an asset, you don’t need to pay tax on the full capital gain. If you own a property for over 12 months, the capital gains tax discount is 50%. So if you make $100,000 profit, you pay tax on just $50,000.

(The 50% discount after 12 months applies to other assets too, like shares. This rule began in 1999. Before that, the tax was calculated on profits that were calculated after taking into account inflation.)

CGT discounts make speculative investing desirable. Without the CGT discount, profits on housing would be smaller, so fewer people would want to use negative gearing.

The two systems work together to increase demand for housing as an investment.

What would happen if we got rid of negative gearing?

If we got rid of negative gearing, some landlords would try to put up rents in order be positively geared. Others would try to sell their properties.

These two effects go in opposite directions. First, rents would increase. But then, if landlords started selling off properties, property prices might fall. That could cause rents to become cheaper.

This is why people fight so much about negative gearing. It is not clear if it is good for renters, and it is not clear if it is propping up the housing market.

Labor’s plan to restrict negative gearing to new properties should help increase demand for new homes, prices of new homes, and supply of new homes. It should shift the rental market towards that sector.

The overall effect on rents and property prices would be very interesting to observe. Confounding any estimate will be the fact that more renters would end up in shiny new flats, while the supply of big old homes as rental properties will probably dry up.

But even the election of a Labor government wouldn’t necessarily mean immediate implementation for these reforms. The property industry will fight tooth and nail, and delays are very likely. Keating himself flip-flopped under pressure on negative gearing — to expect smoother sailing now the property industry is even more powerful is very unlikely.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey