Australia’s Negatively Geared Property Investor Overhang

What is Negative Gearing?

Negative Gearing in Australia

A Growing Army of Loss-Making Speculators

Negative Gearing and Income Levels

Conclusion

One thing that differentiates Australia’s property market from many others is its propensity for leveraged rental property investment, with negative income returns assumed to be covered by future capital gains. This assumption has proved to be correct in recent times as house prices surged faster than rents and incomes since the late 1990s.Negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not initially cover the interest on the loan (income < interest).A negative gearing strategy makes a profit under the following circumstances:1. The asset rises in value so that the capital gain is more than the sum of the ongoing losses over the life of the investment.2. The income stream rises to become greater than the cost of interest (i.e. the investment becomes positively geared).3. The interest cost falls due to lower interest rates or paying down the principal of the loan (again, making the investment positively geared).The investor must be able to fund any shortfall until the asset is sold, or until the investment becomes positively geared (income > interest).A typical negatively geared investment property will remain negatively geared for a number of years, after which the rental income should increase with inflation to the point where the investment is positively geared (the rental income is greater than the interest cost). Positive Gearing occurs when you borrow to invest in an income producing asset and the returns (income) from that asset exceed the cost of borrowing. From this point in time, the investor must pay tax on the rental income profit until the asset is sold, at which point the investor must pay Capital Gains Tax on any sale profit.Negative gearing tax laws in Australia permit property and share investors to offset the cost of borrowing to acquire an income producing asset against all sources of income, not only income generated by the asset. There are no limitations on the income of the taxpayer, the size of losses, or the period over which losses may be offset. By contrast, in some other countries, expenses can’t be deducted against unrelated income, limiting negative gearing to professionals or developers. Deduction of negative gearing losses on property against income from other sources is permitted in several countries, including Canada, Australia and New Zealand.ATO Tax Statistics for financial year 2010-11 show Australia to be a nation of loss-making landlords who remain very exposed to any economic downturn. The availability of negative gearing, along with easy credit and the halving of Capital Gains Tax (CGT) has resulted in property investment surging in popularity. It seems likely that this surge in property investment was driven by the baby boomer generation investing in real estate to minimise tax and save for retirement.In 1998-99 there was a roughly equal number of negatively geared and positively geared investors, however that situation has now changed substantially, with the latest data showing two thirds of all property investors (1.2 million investors) were negatively geared in 2010-11, with aggregate losses totalling $8.9 billion. Aggregate losses in 2011-12 were lower than the 2007-08 peak, when investors claimed a record $9.1 billion in losses. The reduction was due to a drop in mortgage rates which lowered the amount of interest payable. Next year’s ATO data for will also likely reveal a drop in losses due to lower interest rates.The drop in rental returns from 2000 and the surge of negatively geared investment was due to the 1999 government decision to alter capital gains tax rules by halving the rate of tax payable on nominal capital gains earned on assets held for more than twelve months. Under the old CGT system, tax was payable on the total capital gain, adjusted for inflation.This change encouraged speculation on growing house prices, with the understanding that any losses incurred would lower the investor’s total tax liability, while any capital gains would be taxed at half the rate of labour income. The outcome was that investors began to view real estate as a sure fire investment, becoming ‘Ponzi Borrowers’ (Minsky’s term for borrowers who rely on capital gain to repay debt). Losses across all Australian investment properties averaged $4,340 per investor in 2010-11, or 8.7% of average taxable income, while losses for negatively geared investors alone averaged $10,943 per investor in 2010-11, or 22% of average taxable income.Property investment is most popular among high income earners, due to the increased tax benefits as one climbs up the marginal tax scale. The share of property investors residing at each income bracket drops as income levels rise. In 2010-11, one third of taxpayers earning over $180,000 held an investment property, with nearly one quarter negatively geared. By comparison, 15% of taxpayers earning between $50,000 and $60,000 held an investment property, with 11% negatively geared. For negatively geared investors, average net rental losses typically represent 10% to 25% of taxable income. Percentage losses were skewed towards the lower income brackets, while higher income brackets incurred higher dollar losses.Vested interests in Australia’s overpriced housing market frequently claim Australia’s household debt is safe because it is primarily held by high income earners. However, this claim is countered by the ATO data showing negatively geared property investment is chiefly a middle class phenomenon. Furthermore, the 2009-10 ABS Household Wealth and Wealth Distribution survey shows nearly 75% of investment properties are held by individuals aged 45 years and over. This concentration of negatively geared property in the lower-income and older-aged demographics is critical because negative gearing is only attractive as a tax minimization strategy as long as there is labour income against which to offset rental losses. When investors reach retirement age they no longer have labour income to offset their losses against and negative gearing becomes unviable.Older people are likely to be net vendors of real estate and other assets to fund their retirement. The incentive to liquidate real estate will be high among the lower income earners who hold the bulk of negatively geared property. As the oldest boomers turned 65 in 2011, the transition to retirement has officially begun, and this will strengthen over the following decade as more boomers depart the labour force. Pressure to sell will also intensify as Australia’s mining boom unwinds, resulting in higher unemployment and reduced income growth.