Debt always plays a critical role in real estate investment.
Removing negative gearing is in the news again as a potential source of revenue for the government. It can be a lighting rod issue for those who see it as a means of getting on the step ladder of property ownership verses those that see it as an artificial subsidy that worsen housing affordability.
What is negative gearing –
Negative gearing property means an individuals primarily uses the expenses of owning investment property to offset other income tax liability. In the simplest sense the interest cost is higher than the cash flow of the asset but interest expense offset the income tax that would be paid on other sources of income.
From this perspective negative gearing is just like any other business operation where there are only expense and income irrespective on what are the source of income or expense.
Interest on a loan is a result of generating income similar to payments for service providers. The deductability of interest cost is simply a cost of doing business.
Markets can be distorted when the sole reason individual buy properties is to create potential negative gearing situation. Negative gearing means that the cost of holding the investment is higher than the income it generates. We are skeptical of this approach in investing capital for the long run.
Australian housing markets has been in a multi decade bull market. The rise in prices meant that investors are still able to make a decent return with a negative yielding asset. The tax effect of negative gearing is a subsidy that reduces holding cost until the asset is sold at a capital gain or when the market rents catch up.
The negative cashflow nature of the strategy means future returns is dependent on the fact that you can sell the asset at a higher price to some one else. It is a greater fool theory. However investment approach aside, the most common debates on the issue focus on the tax advantages it creates.
Negative gearing property
As result of removing the deductibility of expenses, it would increase pressure on the landlord to make up the shortfall else where or overall market prices adjust to lower values.
While one landlord raising rent can be offset by the tenant leaving but a systemic increase in cost which is what changing negative gearing would leave renters with higher cost across board.
What does removing negative gearing mean? Is it capping the total amount of interest can be deducted on the individual tax return? Will this apply to companies where they can’t deduct interest on debt? Changes in cost of debt as result of tax impact means that role of equity and debt in capital structure will also change.
There will be wide spread ramifications from perceived simple changes to the system. A better solution is to actually to fix the supply issues in the property markets itself.
Also: see our aud jpy analysis on the key factors that would impact the future exchange rate movements.
Can I claim Negative gearing on principal residences? No
The use of interest expense to offset income only applies to investment properties. So it does not apply to interest on primary residences because from a tax perspective it is not a investment but a primary use.
House Prices does go up forever
The removal of the interest deductability can make home investment less attractive but we don’t think removing it will improve long term housing affordability in Australia. Government housing assistance First Home Owner Grants are aimed to help first home buyers but realistically the grants just pushes the prices of units and houses up by a similar amount.
Key negative gearing reform
The biggest obstacle in home ownership aside runaway property bubble sydney is facing is stamp duty. The replacement of stamp duty with land tax would dramatically increase the supply side of the housing equation.
Currently, the low holding cost of real estate coupled with negative gearing means means to some, a vacant lot is worth more than a built lot. Since there is a tax subsidy on cost this meant that existing owners can wait until price rises over time to cashout.
Land becomes a pure speculation bet that long term unimproved land value will outpaced improved value.
A number of state governments have tried to impose stamp duty for foreign investors. The additional tax and stronger apartment supply coming online across major capital cities will slowdown the pace of house price growth.
Transaction costs can be a obstacle for a market to be efficient. Rather removing the transaction cost and introduce a holding cost to the equation, the overall market supply will be more responsive to demand. This would improve overall health and stability of the market.