Negative gearing (Australia)
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Negative gearing is a form of financial leverage where an investor borrows money to invest but the gross income generated by the investment is less than the cost of owning and managing the investment, including interest charged on the borrowings (payments reducing the principal component of borrowings is not included as a cost). The investment generates a negative cashflow until the income rises to exceed the costs, or the asset is sold, at which point a potentially taxable profit is made if the capital gain on the asset exceeds the accumulated losses.
The tax treatment of interest expenses and future gain affects the after-tax return. Losses from negatively geared property investments, share investments, and other commercial business ventures are tax-deductible against other taxable personal income in Australia.
In Australia, negative gearing often refers to borrowing for a residential property investment (e.g. a house or unit), which is made available for rent. In most cases rental values are less than the interest on property value, and the investment thus results negative gearing if the investor borrows a large proportion of the purchase price.
Borrowing to purchase shares whose dividends fall short of interest costs is also called negative gearing. A common type of loan to finance such a transaction is called a margin loan. Importantly the tax treatment is the same, and any investment made where the funding costs exceed the income return is referred to as negative gearing.
Negative gearing by property investors reduced personal income tax revenue in Australia by $600 million in the 2001-02 tax year, $3.9 billion in 2004-05 and $13.2 billion in 2010-11.
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Australian tax treatment of negative gearing is as follows.
- Interest on an investment loan for an income producing purpose is fully deductible, even if the income falls short of the interest. Any shortfall offsets income from other sources, such as the wage or salary income of the investor.
- Ongoing maintenance and small expenses are similarly fully deductible.
- Property fixtures and fittings are treated as plant, and a deduction for depreciation is allowed, based on effective life. When later sold the difference between actual proceeds and the written-down value becomes income, or further deduction.
- Capital works (buildings or major additions, constructed after 1987 or certain other dates) receive a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is on the initial cost (or an estimate), until exhausted. The investor's cost base for capital gains tax purposes is reduced by the amount claimed.
- On sale, or most other methods of transfer of ownership, capital gains tax is payable on the proceeds minus cost base (and excluding items treated as plant above). A net capital gain is taxed as income, but if the asset was held for 1 year or more, then the gain is first discounted by 50% for an individual, or 33⅓% for a superannuation fund. (This discount commenced in 1999, prior to that a cost base indexing and a stretching of marginal rates applied instead.)
The tax treatment of negative gearing and capital gains are generally seen as beneficial to investors for several reasons, including;
- Losses are deductible in the financial year they are incurred, providing nearly immediate benefit.
- Capital gains are taxed in the financial year when a transfer of ownership occurs (or other less common triggering event), which may be many years after the initial deductions.
- If held for more than 12 months, only 50% of the capital gain is taxable.
- Transfer of ownership may be deliberately timed to occur in a year when the investor is subject to a lower marginal tax rate, reducing the applicable capital gains tax rate compared to the tax rate saved by the initial deductions.
However, in certain situations the tax rate applied to the capital gain may be higher than the rate of tax saving due to the initial deductions. For example, if the investor has a low marginal tax rate while making deductions but a high marginal rate in the year the capital gain is realised.
The above may be contrasted with owner-occupiers. Mortgage interest and upkeep expenses on a property used for private purposes are not deductible. However, any capital gain (or loss) made on disposal of one's primary residence is not taxed. (There are rules to apply when changing a property from private use to rented out, or back, and for what is considered one's main residence.)
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The economic and social effects of negative gearing in Australia are a matter of ongoing debate. Those in favour of negative gearing say
- Negatively geared investors support the private residential tenancy market, assisting those who cannot afford to buy, and reducing demand on government public housing.
- Investor demand for property supports the building industry, creating employment.(Highly contentious)
- Tax benefits encourage individuals to invest and save, especially to help them become self-sufficient in retirement.
- Startup losses are accepted as deductions for business, and should also be accepted for investors, since investors will be taxed on the result.
- Interest expenses deductible to the investor are income to the lender, so there's no loss of tax revenue.
- Negatively geared properties are running at an actual loss to the investor: even though the loss may be used to reduce tax, the investor is still in a net worse position compared to not owning the property. The investor is expecting to make a profit only on the capital gain when the property is sold, and it is at this point that the treatment of the income is favoured by the tax system, since the only half of the capital gain is assessed as taxable income, providing the investment is held for at least twelve months (before 2000-2001, only the real value of the capital gain was taxed, which had a similar effect). From this perspective, distortions are generated by the fifty percent discount on capital gains income for income tax purposes, not negative gearing.
Opponents of negative gearing say,
- It encourages over-investment in residential property, an essentially "unproductive" asset, which is an economic distortion.
- Investors inflate the residential property market, making it less affordable for first home buyers or other owner-occupiers.
- In Australia in 2007, 9 out of 10 negatively geared properties are for existing dwellings, so the creation of rental supply comes almost entirely at the expense of displacing potential owner-occupiers. Thus, if negative gearing is to exist, it should only be applied to newly constructed properties.
- It encourages speculators into the property market, inflating for instance the Australian property bubble that began in the mid-1990s, partly the result of increased availability of credit that occurred following the entry of non-bank lenders into the Australian mortgage market.
- Tax deductions and overall benefits accrue to those who already have high incomes. This will make the rich investors even richer and the poorer population even poorer, possibly creating and prolonging a social divide between socioeconomic classes.
- Tax deductions reduce government revenue by a significant amount each year, which either represents non-investors subsidising investors, or makes the government less able to provide other programs.
- A negatively geared property never generates net income, so losses should not be deductible. (Deductibility of for example business losses when there was a reasonable expectation of gaining income is well-accepted, the point against negative gearing is that it will never generate income. Opponents of full deductibility would presumably at least allow losses to be capitalised into the investor's cost base.)
In July 1985 the Hawke/Keating government quarantined negative gearing interest expenses (on new transactions), so interest could only be claimed against rental income, not other income. (Any excess could be carried forward for use in later years.) What is less appreciated is that Hawke/Keating introduced negative gearing only six months prior. Previous to their initial decision the Income Tax Assessment Act 1936 (As Amended) had quarantined all property losses from deduction against income from personal exertion (other business or salary and wage income). Any losses incurred in any one year would be accumulated on a register and would only be allowed as a deduction from income from property in succeeding years. In so doing property income and property losses were in one 'bucket' and personal exertion income and losses were in another 'bucket'.
This ensured that either at personal level and more importantly at a national level, that property losses would not be subsidized by income from personal exertion. In applying this formula, all previous governments thereby isolated and consequently discouraged capital speculation being subsidized from the general income tax receipts pool.
Keating initially changed this legislative treatment only months prior to attempting to revert to the original. Politically, those who took immediate benefit from the initial change, made false claims that any attempt to remedy the situation would give rise to an explosive increase in rent costs. There was no statistical or real world data to support this claim, other than a small blip in rentals in a small part of Sydney. This was enough to have Hawke/Keating submit to the landlords demands and remove the attempt at repairing the initial decision.
This is what is described below as a dampening of 'investor enthusiasm', which is not quite the context, as the previous rules (which Keating had firstly removed and then attempted to reinstate and in quick time) had been in place since 1936.
The result was a considerable dampening of investor enthusiasm; although the new capital gains tax introduced shortly afterwards (September 1985) may have contributed too. After intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, the government restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.
An alternative view
The view that the temporary removal of negative gearing caused rents to rise has been challenged by Saul Eslake, who has been quoted as saying, "It's true, according to Real Estate Institute data, that rents went up in Sydney and Perth. But the same data doesn't show any discernable increase in the other State capitals. I would say that, if negative gearing had been responsible for a surge in rents, then you should have observed it everywhere, not just two capitals. In fact, if you dig into other parts of the REI database, what you find is that vacancy rates were unusually low at that time before negative gearing was abolished." 
While Saul Eslake's comment is correct for inflation adjusted rents (i.e. when CPI inflation is subtracted from the nominal rent increases), nominal rents nationally did rise by over 25% during the two years when Negative Gearing was quarantined. Nominal rents rose strongly in every Australian capital city, according to the official ABS CPI Data. However it has not been proved that this strong rise in rents was entirely a direct result of the Negative Gearing quarantine. 
Effect on Housing Affordability
In 2003, the Reserve Bank of Australia (RBA) stated in their submission to the Productivity Commission First Home Ownership Inquiry, "there are no specific aspects of current tax arrangements designed to encourage investment in property relative to other investments in the Australian tax system". However, they went on to say, "most sensible area to look for moderation of demand is among investors,” and, “the taxation treatment in Australia is more favourable to investors than is the case in other countries." "In particular, the following areas appear worthy of further study by the Productivity Commission: 1. ability to negatively gear an investment property when there is little prospect of the property being cash-flow positive for many years; 2. benefit investors receive when property depreciation allowances are 'clawed back' through the capital gains tax; 3. general treatment of property depreciation, including the ability to claim depreciation on loss-making investments."
In 2008, the Senate Housing Affordability report echoed findings of the 2004 Productivity Commission report. One recommendation to the enquiry suggested that 'Negative gearing' should be capped and that "There should not be unlimited access. Millionaires and billionaires should not be able to access it, and you should not be able to access it on your 20th investment property. There should be limits to it.
In comparison to other countries
Australia, Japan and New Zealand allow unrestricted use of negative gearing losses to offset taxes due to income from other sources. Several other OECD countries allow some offsetting with restrictions imposed, including; USA, Canada, Germany, Sweden, and France. Applying tax deductions from negatively geared investment housing to other income is not permitted in the UK or the Netherlands. With respect to investment decisions and market prices, other taxes such as stamp duties and capital gains tax may be more or less onerous in those countries, increasing or decreasing the attractiveness of residential property as an investment
- RBA Submission to Productivity Commission Inquiry - First Home Ownership
- 2008 Senate Housing Affordability report Chapter 4.57
- http://www.austlii.edu.au/au/journals/eJTR/2005/4.html#Heading447 "Quarantining Interest Deductions for Negatively Geared Rental Property Investments" 
- http://www.rba.gov.au/publications/rdp/2006/pdf/rdp2006-12.pdf Housing and Housing Finance: The View from Australia and Beyond, RBA 
- Australian Democrats Negative Gearing Issue Sheet for the 2004 Election (PDF)
- Australian Taxation Office Rental Properties Guide 2005, product NAT 1729-6.2005
- Real Estate Institute of Australia Policy Statement on Negative Gearing, as of October 2005
- Negative gearing: The three facts that will challenge your assumptions, Property Observer, 2013