On ABC radio this morning, economist Saul Eslake put forward the view that negative gearing was an unwarranted tax concession for the rich and as an unfair anomaly in the present system. In reality, it is neither.
When an investor borrows to buy an investment property, the net return will be the rent received less any outgoings and the interest on the loan. If the expenses and interest exceed the rent, then the investor is making a loss and the property is said to be negatively geared. These losses can be used to offset other income for tax purposes.
While negative gearing is most frequently talked about in the context of property investment, it is also available for investments in shares and other income producing assets.
Australia has an income tax system which philosophically is designed to tax profits net of the cost of achieving those profits. If any positive items give rise to taxation then it is perfectly reasonable that negative items should be treated as offsets. This principle applies to all business transactions.
As the interest expense is typically the greatest cost to an investor providing rental accommodation (particularly in the early years) if you are not going to allow a deduction for interest and tax the investor on the gross rental income, then to be consistent, you will likewise have to start taxing business on their revenue rather than their profits – clearly an absurd proposition.
It should also be remembered that if an investor’s strategy is correct, then in the long run there will be gains which are more than sufficient to offset the losses of the early years. Both the investor and the ATO will end up in front.
CGT concessions ignore inflation
Housing, like other investments, is also eligible for a 50% capital gains tax discount if held for more than twelve months. Many are comfortable with the idea that tax policy encourages long-term investment rather than speculation, but the benefits of this concession are grossly overstated. If you hold a property for 20 years and it doubles in price, much of your gain would simply be attributable to inflation. Often all this concession provides is some relief from being taxed on illusory asset price increases due to inflation.
Items that depreciate eventually have to be replaced
Real estate marketers love to promote the idea of depreciation as a great tax minimiser. The tax code recognises that the assets used to produce income decline in value over time with wear and tear. This is called depreciation. With real estate investments you can also claim a deduction for depreciation, but this is not a freebie from the tax office. Fittings and hot water systems etc. really do wear out and need replacing eventually. The extra cost of those replacements will come out of your pocket and the depreciation cycle will start again.