For the best part of a century, Australian property investors have enjoyed a generous tax arrangement found in few other countries: the infamous “negative gearing”.
Now, sweeping reforms to limit negative gearing to new builds and also change the way capital gains are taxed have become law.
The federal government hopes to give first-home buyers a better shot at buying existing homes and at the same time redirect investor cash towards increasing housing supply.
However, some of the practical implications of these changes haven’t received much attention. Here are three possible side effects which could now distort the property market in unexpected ways – including favouring investors.
What is negative gearing?
Most people associate negative gearing with real estate. But it can apply to any kind of investment.
Here, gearing simply means borrowing money to invest. And if an investment is negatively geared, it means the expenses related to owning it (such as the interest payments on a mortgage) are greater than the income it generates (rental payments).
For property investors, these expenses could also include other costs, such as real estate agent fees, council and water rates, and so on.
Under the old rules, high income earners were able to use a rental loss immediately to reduce their tax bill on other income, such as a salary.
Coupled with the way capital gains were taxed at a 50% exemption, the arrangement allowed many property investors to tolerate – perhaps even welcome – a rental property running at an apparent loss for tax purposes, while the property’s value continued to climb.
What’s changed?
Importantly, negative gearing hasn’t been abolished altogether. It has just been heavily restricted in the context of residential property.
Under the old rules, any rental expenses exceeding rental income could be deducted against an investor’s salary, business or other income. For purchases made after the cut-off time of 7:30pm on budget night on May 12, this arrangement is reserved for new builds only.
For existing properties, unused excessive expenses are now “quarantined”. This means they can only be used to offset future rental profits or the profit an investor makes when they eventually sell the property – not against other forms of income.
At the same time, the 50% capital gains exemption has been replaced by an “indexation system” that adjusts the cost of a property to take inflation into account.
Importantly, anyone who purchased a property before the cutoff time has had their arrangements “grandfathered”, meaning they can continue to deduct excess rental expenses from other income.
However, some workarounds and other distortions still exist.
Joel Carrett/AAP
Converting home into an investment
First, for people who currently own just one property to live in, a unique door remains open.
Under the legislation, to be eligible for the old negative gearing arrangements, a property only needed to be owned (or under binding contract) at the cutoff time. It did not need to be an investment property at this time.
By buying another property in the future and moving into it, some people may be able to technically give an existing build (their former home) the traditional negative gearing treatment once it becomes a rental property.
While this “loophole” may not have huge impacts on the housing market, some economists have speculated it could disincentivise some homeowners from selling property, to retain the option to negatively gear later.
A big advantage for ‘grandfathered’ landlords
Under the new laws, “grandfathered” landlords (who owned properties before budget night) get a massive structural advantage. And this isn’t just because they can continue to negatively gear their existing properties.
If those older properties become profitable (positively geared) as the mortgage is paid off and rents rise over time, these investors would normally start paying tax on their rental profits.
However, the new tax law allows these investors to use the excess profit from their old portfolio to immediately absorb and offset the quarantined losses of newly acquired properties.
Basically, they keep some of the tax advantages of negative gearing – even though their properties aren’t making a loss for tax purposes.
Rental losses could get ‘trapped’ in property
As a result of the new “quarantine” rule, some investors will end up with rental property expenses they have not been able to deduct, leading to a pool of undeducted rental property expenses.
Those expenses are not completely lost − they can potentially be used to reduce the tax on any capital gain realised when the property is sold.
However, because these losses can’t be used to offset any other types of income (only those related to property), landlords have an incentive to hold onto property until they are sure of a capital gain large enough to make use of these undeducted rental property expenses, which are otherwise “trapped”.
If investors delay selling for tax reasons, the reforms may reduce the supply of established homes available for sale, placing upward pressure on housing prices.
Making housing more affordable?
Supporters of these changes argue that this is a great chance to make houses more affordable and create opportunities for new entrants to get into the property market more easily.
The theory is straightforward. If you strip away the tax benefits of buying existing houses, wealthy investors will stop outbidding everyday people just trying to buy a home, cooling down property prices.
The are early signs Australia’s housing market is beginning to cool. However, it remains to be seen if the end of negative gearing will have a more long-term impact on housing affordability in Australia.
Disclaimer: This article is not tax advice, it is for educational purposes only. Taxpayers should seek advice from a registered tax agent or suitably qualified professional.
