By 2353NM

One of the points of difference between the Turnbull government and the Shorten opposition is negative gearing. We would all still be here next week if the current regime and the proposals were discussed in full, so how about we attempt to do the ‘helicopter’ version. Just keep in mind that this article is general in nature and doesn’t consider your financial situation.

Broadly speaking negative gearing is a method of reducing your taxable income. You do this by purchasing an asset where the expenses from the asset are greater than the income you gain from the asset. As the asset is ‘income producing’ and you lose money on it, you can take the loss from other taxable income when it comes time to doing your tax return.

To negative gear effectively, you need to purchase something that will remain steady or increase in value. So buying a car and leasing it to an Uber operator wouldn’t be a good idea because the car is almost certain to decrease in value, regardless of the use it gets. By contrast, property and shares are excellent choices as both asset classes can produce an income (income producing) and frequently the expenses incurred in the purchase and maintenance of the asset (interest, fees and in the case of property, rates, maintenance, body corporate and leasing fees and so on) can easily and quite legitimately outweigh the income received from the asset. When you add up the costs, take away the income and then subtract it from your income from other sources such as your job, if you’ve done it correctly, your income for taxation purposes reduces to something under $80,000 per annum and voila, you qualify for one of the lower levels of income taxation.

Traditionally property and shares rise in value over time, so as well as writing off your losses you can usually sell for more money than you paid when the time comes. This is known as a capital gain. Capital Gains Tax is where you make a profit on the sale of an asset and the government of the day puts their hand out for some of the profit. Simplistically, the tax is calculated by adding the purchase price to the price of any capital improvements (say a new kitchen and carport), then subtracting that number from the sale price less the costs of the sale (real estate fees, legal fees and so on). If you hold the asset for more than 12 months, the current practice is for the tax to be calculated on only half the profit. If you hold a property for say four years and make $50,000 in capital gains, the government will only tax you at your marginal rate as if the profit was only $25,000.

On Easter Monday, Fairfax titles around Australia were reporting one of the strange outcomes of the current negative gearing policy settings. To be blunt

Sydney’s housing affordability crisis is being artificially inflated by up to 90,000 properties standing empty in some of the city’s most desirable suburbs, experts say.

While there is always some variation in rental returns, it seems that property in areas with higher capital growth are statistically more likely to be empty. And we’re not just talking ‘margin of error’ stuff here: in Sydney City, Haymarket and The Rocks, one in seven dwellings (somewhere where people are allowed to live) is vacant. If you go way out west, areas around Casula and Green Valley have a vacancy rate of around one in forty-two. Melbourne isn’t immune to the empty property trend with an estimated 82,724 or 4.8% of properties across the city being empty.

Admittedly, some of the empty dwellings in Sydney City and Melbourne may be on the market, undergoing major renovation or people are on extended holidays — but certainly not all of them. Those that look at the real estate advertising, either on line or in the ‘dead tree’ format, would be well aware of articles discussing the current capital gains that can be made in real estate with barely a mention of rental returns. Late in March, the question was whether Hobart or Brisbane were the places to buy now as housing prices were likely to increase substantially in the short term.

While the Sydney market peters out, Brisbane and Hobart are warming up with the Australian Bureau of Statistics Residential Property Price Index rising 2.5 per cent in Hobart and 1.6 per cent in Brisbane over the December quarter.

Domain Group data for the 12 months to January 2016 also showed Brisbane’s median house price increased 2.5 per cent to $485,000, while its median unit price was flat at $410,000. Hobart’s median house price grew by 2.4 per cent to $340,000 and its unit price jumped 9.7 per cent to $290,000.

There are a few fundamental problems with property investment. While those who already own property in one of the ‘hot spots’ are laughing all the way to the bank — sometimes to get the equity loan for the overseas trip, the massive renovation or the fancy car — those that grew up or rent in the locality can’t afford to purchase a first property in the area they are familiar with. In addition, those who purchase properties for investment can’t carve off $50,000 worth of the property should they have a requirement for the cash in a hurry.

The real problem here is that people are buying property for the wrong reason. A property is a place for people to live. It should be noted that a property only has to be available for rental before the ATO will allow negative gearing, there is no requirement that the property be rented, the property be advertised for rental if it is vacant or the rent value be appropriate for the market. The cynical could suggest that the way to maximise your negative income from a property is to leave it vacant as no income less expenses adds up to a greater tax loss than some income less expenses. The short term pain is alleviated by the increase in value of the property when the property is sold due to favourable capital gains taxation treatment where you keep something over 75% of the profit.

Like property, there are a number of factors that usually indicate if a share purchase should be made. In contrast to the oft repeated mantra of property sales “location, location, location”, the intrinsic worth of a share to an investor is usually calculated using a number of ratios. They are Price/Earnings Ratio; Earnings Yield; Return on Equity and Dividend Yield. This Fairfax article discusses what each of these terms actually means, should you wish to know more. For the moment let’s just consider one point; most of the share indicators are based on the price of the share in relation to the dividend (payment of a small proportion of the profit from the company’s operations).

Property prices and affordability are currently based on what capital gain is likely to be made over the short to medium term, not what rental income is received should the inner city unit you have purchased as an investment be actually used for its intended purpose. To be fair, some of the demand for property is generated by overseas residents attempting to purchase assets in Australia but this is estimated to be about 15% of the market, rising to 20% by 2020.

The point to all of this is that investors have manipulated the property market with the co-operation of the government. They have artificially increased the value of property, diminished the ability of your and my kids ever owning a place to call home, created the potential for a housing bubble and potentially reduced the number of ‘real’ properties available for rental or purchase which has caused a housing shortage.

There is also a waste of resources in having one in seven properties in Sydney City empty. The electricity and water supply organisations have to assume the property will be used for the intended purpose when calculating the potential demand for electricity, water and other services. This causes an overbuilding of infrastructure to service the affected areas — capital that could better be used to reduce utilities prices.

It seems that if you buy a property you can game the negative gearing/capital gains tax systems better than if you buy shares. If your property is empty, there is no income to account for when ‘losing’ money on the rates and taxes incurred when owing a property. Most Company Boards wouldn’t consider a request that they don’t pay a dividend this year solely to assist you in maximising your potential for reducing your taxable income.

Surely any investment decision should be made on the return expected on the investment, as well as the potential for profit on the sale? Most are, but for some reason the potential rent that could be earned on property is discarded. Some are happy to only accept the potential future capital gain assuming that someone in the future wants to buy a five-year-old property that no one has ever lived in. It’s too bad if the market does crash for some reason or other. Ironically, the rental income per square metre in inner city Sydney would be significantly greater than the rent you could expect to receive at Casula or Green Valley, so the ‘price/earnings ratio’ of an inner city property would be more attractive than the ratio for a property in the outer suburbs where vacant properties are statistically fewer.

Turnbull and the Coalition want to keep the existing policy settings; probably a good thing if you need to reduce your taxable income to under $80,000 and can’t use other tax management practices such as companies, splitting income etc. Shorten and the ALP don’t. Shorten wants to remove the ability to negative gear property unless the particular property is a ‘new build’. While the first owner of a property could negative gear the property regardless of whether a tenant was in place, logically a long standing tenant in a property paying a realistic rent per week would become the preferred situation if the property was onsold.

Shorten also claims that considerable research, time and effort has gone into the ALP’s proposed policy, that will go part way to addressing issues such as tax avoidance, housing availability and housing prices being out of reach if you are unfortunate enough to be trying to purchase your first property somewhere close to services like shopping, education, transport and health care in one of our larger cities.

It is probable that investors will return to the fundamentals of investment should the ALP scheme be implemented leading to a stabilisation of housing prices, an increase in property available for rental and slower rates of housing price growth. This will come about because investors won’t be pushing first home buyers out of the market and properties won’t remain empty for years.

There is also significant upside when it comes to eliminating the budget deficit (we’ll leave the inevitable discussion on Modern Money Theory for another time). The Balanced Budget Commission, established by the Committee for the Economic Development of Australia, believes the budget deficit can be eliminated by 2019.

The Commission finds that in order to eliminate the budget deficit by 2018‒19, spending should fall by $2 billion and revenue should climb by $15 billion.

It sets out five options for achieving that goal, all of which include a cut in the discount applied to the capital gains tax along the lines proposed by Labor.

In response to Turnbull’s claim that removing negative gearing and increasing capital gains tax will reduce investment, Commission Chair Mr McClintock said:

It doesn’t mean it is a bad activity, but you can say there is too many billions of dollars going into that activity and we cannot afford that. With things like negative gearing, the inflation rates are lower, there is a strong argument to suggest you can lower that and still produce an environment where people are willing to invest. Our judgment call is that, yes, of course, it will have some marginal impact, so will everything, but it’s a manageable impact.

Really, it doesn’t take the skills, research and knowledge of the CEDA to suggest future affordability of housing and availability of properties for rent or purchase outweighs the perceived right of others to reduce their contribution towards the provision of services to the entire community — aka minimisation or avoidance of taxes. Unfortunately, only one of the two major political parties has demonstrated that they see the connection.

Also by the author:

Perceptions of corruption

The small government myth

Malcolm’s Magic Pudding

May your god go with you