There is a simple way to remove the taxpayer
subsidised market distortions of negative gearing of property investments:
allow losses to be carried forward, but not offset against other income, such
as wages.
For example, suppose someone has an
investment property which earns $25,000 pa rent and has interest costs of
$30,000 pa, plus other costs of $5,000 pa. The investment is making an
accounting loss of $10,000 pa. The current law allows the investor to deduct
this $10,000 loss from their salary (or other) income in their yearly tax
return. For high income earners ie. those earning above $180,000, this $10,000
deduction saves $4,900 in tax.
The alternative is that the $10,000
would not be allowed to be deducted from salary or other income. Rather, it
could be carried forward to future years and only deducted from future property
investment income. A modification would be to class all income producing investments
eg. property, bonds, equities as being of the same type and allow income and
expenses (including interest) to be combined within this class. This
effectively allows investment property to be negatively geared only against profit
generating investments in that class.
This is not an unusual or radical
solution: in fact it is the current norm in tax law.
The underlying principle is that
losses can only be claimed as deductions if a business intends to make a
profit. It is understood that businesses may have several years of losses in
their start up phase, or in difficult market conditions. However, the goal of
the business should be to grow revenue and eventually become profitable.
The Australian Tax Office does not
allow “non-commercial losses” to be offset against other income. That means a business activity
must be structured with the intent of being, or at least becoming profitable.
Deductions for losses derived from “hobby businesses” or structures designed to
run at a loss through cross invoicing, transfer pricing or similar are
disallowed. The circumstances and tests for allowable deductions are listed on the ATO website.
The rules around offsetting losses
from one business activity against profits from another are part of Division 35 of the Income Tax Assessment Act. They essentially boil down to whether
or not the business activities are deemed separate or substantially similar.
For example, a winery with its own restaurant would be considered similar
business activities, so if the restaurant made a loss, that could be deducted
from winery profits. A car repair business which bought a florist could not
offset losses of the florist against profits of the other, because those would
be considered separate business activities.
In the latter example, the losses of
the florist would be carried forward and only offset against future profits of
the florist business.
This is exactly the rule I am
proposing for property investment. Investing in property (and other tradable
financial instruments) is clearly a separate business activity from most people’s
wage generating employment. Thus, it should be treated according to the
existing tax rules for separate business activities.
The problem with negative gearing is
that the property investment is deliberately structured to make a loss. When
the current portfolio begins to generate positive cash flow, more property is purchased
to re-establish the negative gearing. Thus, those deliberately generated losses
should be carried forward and offset against future investment profits, not
deducted from salary income and subsidised by the taxpayer.
A meaningful effect of this change in
policy would be to force property investors to pursue strategies designed to
eventually return significant profits, or else the losses carried forward will
not be able to be used. Note that this does not prevent investors from negative
gearing: it requires them to make investment profits to deduct those losses. After
becoming cash flow positive, an investor could add another negatively geared property
into the portfolio, reducing profits or even creating an accounting loss, which
would be carried forward to future financial years.
This simple change in policy brings the
tax treatment of property investment into line with that of other asset classes.
Disallowing negative gearing against salary income will cause some investors to
have a lower price ceiling, however those with existing, cash flow positive
portfolios will not have their strategies or price ceilings materially
affected.
Contrary to self serving, dishonest
and hysterical claims
that restricting negative gearing could cause property prices to crash, the downward
pressure on prices through decrease in demand will be modest, certainly smaller
that the effect of a couple of interest rate hikes, when they eventually
happen. There will not be waves of forced sales because there will not be waves
of investor defaults. After the lessons of the GFC, banks will certainly not do
any forcing based on lower debt coverage ratios alone.
With the property market severely
overheated in most capital cities due to chronic undersupply, interest rates at
historic lows and forward rates expecting further falls, this is probably the
best time we’ll get to make sensible changes to negative gearing.
Coupled with the gradual, longer term
effect of more investment in public housing, this change to negative gearing will
help control the excessive growth of Australian capital city property prices,
which has been fuelled by low interest rates, undersupply and high immigration
of money. Additionally, after causing initial hardship to those currently in
negatively geared positions, it will lead to decreased risk in investors’
positions and thus lower credit risk and capital charges for lenders.
