What would happen if negative gearing was abolished?

The Labor party, in particular Bill Shorten has been calling for the tax concessions on properties that are negatively geared to be abolished. Negative gearing is essentially when a property investor is making a loss from his investment property as rental income received is not covering the expenses incurred by owning the property in question. This could be because:

i) the investor has paid too much for the property,
ii) the investor hasn’t enough funds available to pay a large enough deposit so that the property would be positively geared, or
iii) the investor is possibly not charging enough in Rent to cover expenses.Is this approach by the opposition leader and those supporting this move logical or misguided?The argument is that house prices are continuing to rise faster than incomes and therefore housing affordability has been stretched for many Australians. It is suggested that the demand for ownership of investment properties has pushed prices beyond where prices would be if everyone was satisfied with only owning the property that they lived in. This is certainly a valid point but it also misses some vital benefits that renters derive by renting rather than owning in the short to medium term (less than three years).

An economy needs to be able to provide rental properties as not every one needing accommodation is looking for permanent accommodation and hence many not want to incur the costs of owning a home at a particular time. For example, it often makes sense for a young couple to rent their first home. Firstly, it’s a lot cheaper to do so than to incur the costs of owning a home particularly if they do not intend to stay in that home for more than three  years as can be seen in  table 1  below.

TABLE:1

After the first year of buying a property (in Western Australia) the owner would be $27,723 worse off than the renter. This is mainly due to the $24,575 in acquisition costs and a possible $17,094 in disposal costs at the start of the second year. Further, the mortgage is likely to have been higher than what could have been received in rent by $6,900. On the plus side, in a perfectly linear world the property would have appreciated, by say 4%, giving a (taxable) capital gain of $20,000 in the first year to negate some of the losses.

TABLE 2:

So, provided that there are linear property escalations of 4% per year, it could take at least three years of ownership to break even with the outlay in a rental scenario. If property growth was halved, it extends from three years to five, and if there was no growth the period for break even extends beyond ten years. The key to shortening the break-even point is that there must be capital appreciation on the property.

But let us take a look at what the likely outcome would be should negative gearing get booted from our landscape.

In the short term, House Price growth will slow down

The shameful scenario here proposed by Labor is that the ‘mum and dad’ investors who are essentially the base of support for Labor would be largely excluded from being able to invest in an investment property. It would simply be more draining on their cash flow and their financial resources. The wealthier individual with financial resources would be able to make a higher deposit and neutrally gear their investment. Here, the income and cost offset each other. These investors will remain in the market, but prices will likely fall as the mums and dad’s are no longer competing for available stock. If prices do fall, for some renters who might want to own their own homes, the cost of a mortgage will be a lot closer to what they are paying to rent. Investors who may be unable to soften their payments through the previous tax deductions they derived, may be forced to increase rentals where possible. Where this isn’t possible they may off-load their properties which could also cause prices to potential drop if the market becomes over supplied, but as priced drop the difference between renting and owning becomes more of an incentive to own and this will offer support to property prices.

It is worth bearing in mind that there are other countries, such as the UK, where there have been no tax incentives yet they continue to experience higher prices than we have seen happen in Melbourne and Sydney.”

 Australia has gone down this pathway before with Labor back in 1985. Losses on property were quarantined so that losses had to be offset against current or future profits on property rather than being offset against any income. It took two years for the decision to be reversed in part because of the tight rental market in both Perth and Sydney.

The impact on rental prices in most cities was negligible, but the impact in Sydney and Perth was significant. Rental prices increased causing severe stress on renters, but investor felt the financial pressure too and began selling off investments which in turn caused house prices to come under downward pressure. Today, most of Australia’s capital cities have much tighter rental markets which suggests that history may well repeat itself.

The original intent of negative gearing was to encourage the development of new properties, and since the suggested changes to negative gearing would mostly affect established properties, investors would wisely refocus their attention on new and off-the-plan properties to maximize their returns from this asset class.

However, it is interesting to note that Sydney has experience significant hike in property prices between the period March 2011 and March 2017. Property prices rose by more than 70%. In Perth, over the same time period prices only rose by 2.5%. A key reason for this has to do with State based GDP or GSP.  House prices usually track well with year on year changes in GDP. Part of GDP is made up of consumer spending, investment by firms and borrowing and expenditure by government. Government expenditure is raised through GST, Stamp Duty and Royalties among other things. Hence, when a state is experiencing a slow down in the property market, stamp duty, which can easily make up 25% of the state revenue received drops significantly further exerting downward pressure on house prices. When the property market is experiencing higher demand, receipts from stamp duties increase which in turn increased funds for government to spend in that state which in turn further buoys the property prices.

 

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