Some politicians and academic commentators like to depict negative gearing as primarily a tax avoidance device and a rort by the well-off on the rest of the community. They therefore call for its "abolition". Of course, what they really mean is that they want a change to the tax rules to deny deductibility to interest which exceeds the net return from an investment property rather than the outlawing of a negative return itself.
Inevitably, there will always be some investments which have lower returns than the interest bill on the loans undertaken to acquire the investments concerned - for example, because of start-up periods or because things do not work out as planned.
In the case of property, negative returns can arise simply from unexpected vacancies or essential but one-off repair bills. These economic facts of life have nothing whatsoever to do with tax minimisation.
EFFECT ON THE REVENUE
Actually, there is not as much loss of revenue to the authorities from negative gearing as most critics believe, because for every dollar of interest claimed as a tax deduction by a borrower there is a corresponding dollar of interest assessable to a lender.
Negatively geared investments are not confined to the super-rich. In many cases the borrower will be an ordinary Aussie battler on less than the top marginal rate of tax but still keen to have a tax saving, while the bank or other lending institution will through the imputation system effectively include recipients paying the top marginal rate of tax on the interest.
Investments which start off being negatively geared usually become positively geared after a few years, as rents rise and/or as the outstanding loan balances fall. Over the life of a typical investment the return will be positive. In such cases there is a deferment of tax rather than any avoidance.
Furthermore, by the time the borrowing becomes positively geared it is probable that - because of bracket creep - many of the above-mentioned Aussie battlers will themselves have become subject to the top marginal rate of tax.
Property investment is normally engaged in as a profit-making exercise - and one which puts the investor concerned at some risk. If profits are to be taxed then as a matter of morality losses ought to be allowed as legitimate deductions - as happens in all other commercial transactions.
DRAWING THE LINE
There is also the question of where to draw the line. Should the withdrawal of tax deductibility apply only to property investments or to other classes of assets as well - shares, units in property trusts, business assets generally?
Wherever the line is drawn anomalies will arise in relation to persons on either side of it. Furthermore, enterprising taxpayers will just rearrange their affairs in the light of any new regime and the revenue authorities will be no better off.
Legislation dealing with the tax deductibility of the excess interest on negatively geared property transactions could take many forms. It could, for example, involve the complete denial of deductibility for such excesses for all time. Less severely, it could involve the quarantining all interest in excess of the net rent (gross rent less expenses) but with the right to carry forward any undeducted amounts for use in a subsequent tax year, to the extent that the interest bill was then less than the net rent. Such an approach could be used either on a "per individual property" basis, or - more generously and more reasonably - on a "per property portfolio" basis.
Alternatively again, the excesses could be used to write up the cost base for capital gains tax purposes. By virtue of the 50 per cent discount formula this would have the effect of denying a deduction to 50 per cent of the excess interest (as well as deferring the claim) - unless, of course, the rules were altered to fix up this rate anomaly. The advocates of abolition really need to spell out what they have in mind.
INVESTORS CAN GET BURNT
It should also be remembered that investors who buy properties regardless of their investment merits just in order to claim a tax loss run the real risk that they will be making an actual loss as well.
THE HOUSING MARKET
In the short term, the prices of existing housing stock may well fall following the enactment of legislation restricting interest deductibility, as investors pull out of that corner of the market. However, in the long term prices would rise as new construction dried up, thus reducing the supply of houses without any corresponding reduction in demand.
Naturally, this would also lead to increased unemployment in the building and construction industry.
Higher prices would naturally also mean higher rents, as housing investors need a return on their money comparable to that available from alternative investment opportunities.
Low income tenants would be particularly badly hit, as most properties which change hands after the commencement of an adverse tax regime would pass from investor-owners to owner-occupiers rather than to other investors who, with negative gearing interest deductibility, would have been willing to be residential landlords.
Far from helping the less well-off house purchasers and tenants, the abolition of tax deductibility for interest would hurt these persons and increase the pressure on governments to put up public monies in order to fill the hole left by the withdrawal of private funds.
© N E Renton 2003-2005
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