Negative gearing

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Negative gearing is a form of financial leverage where an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. (When the income does cover the interest it is called positive gearing.)

A negative gearing strategy can only make a profit if the asset rises in value by enough to cover the shortfall between the income and interest which the investor suffers. The investor must also be able to fund that shortfall until the asset is sold. The tax treatment of interest expenses and future gain will affect the investor's final return too. Tax rules vary from country to country.

Negative gearing on property is only found in Canada, Australia, and New Zealand.

1 Australia
2 See also

[edit] Australia

In Australia, negative gearing usually refers to borrowing to buy a residential investment property (house, unit, etc) which is rented out. Almost everywhere rents are less than interest on property value, leading to negative gearing if the investor borrows say 80% or 90% of the cost. Loans of up to 100% are even possible.

The same sort of borrowing to buy shares, with dividends possibly falling short of interest costs, is generally called a margin loan rather than negative gearing. This is done much less commonly, but the tax treatment is the same.

[edit] Taxation

Australian tax treatment of negative gearing is as follows

Interest on an investment loan for an income producing purpose is fully deductible, even if the income falls short of the interest. Any shortfall ends up offsetting income from other sources, such as wage and salary income for an individual.

Ongoing maintenance and small expenses are similarly fully deductible.

Property fixtures and fittings are treated as plant, and a deduction for depreciation is allowed, based on effective life. When later sold the difference between actual proceeds and the written-down value becomes income, or further deduction.

Capital works (buildings or major additions, constructed after 1987 or certain other dates) receive a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is on the initial cost (or an estimate), until exhausted. The investor's cost base for capital gains tax purposes is reduced by the amount claimed.

On sale, capital gains tax is payable on proceeds less cost base (and excluding items treated as plant above). A net capital gain is taxed as income, but if the asset was held for 1 year or more then the gain is first discounted by 50% for an individual, or 33 1/3% for a superannuation fund. (This discount commenced in 1999, prior to that a cost base indexing and a stretching of marginal rates applied instead.)

If interest shortfall is viewed as accumulating in the investment then the deduction means it's compounding pre-tax, and when taxed the rate is the lower capital gains tax.

Depreciation and capital works deductions compensate for non-cash expenses of wear and tear or other progressive deterioration. But if the rates allowed exceed the actual life (eg. the 2.5% on buildings implies 40 years) then the excess of the deduction lets the taxpayer effectively defer tax liabilities (always an advantage). In the case of capital works that excess would move a small amount of income to capital gain too (the latter taxed at a lower rate).

These rules may also hurt an investor, for instance if one's tax rate while deducting is low but then is high in the capital gain year. Or if a capital loss is incurred then it cannot be claimed against income, only other capital gains.

In any case, the way initial expenses and later gains are treated separately and differently means only a careful and detailed calculation can show the final after-tax return. Assumptions must be made about loan interest rates, maintenance expenses, fittings life, capital appreciation, and future tax rates. Then one can consider risk against benefit.

The above may be contrasted with owner-occupiers. Mortgage interest and upkeep expenses on a property used for private purposes are not deductible. But any capital gain (or loss) made on disposal of one's primary residence is tax-free. (There are rules to apply when changing a property from private use to rented out, or back, and for what is considered one's main residence.)

[edit] Social Matters

The economic and social effects of negative gearing in Australia are a matter of ongoing debate. Those in favour of negative gearing say

Negatively geared investors support the private residential tenancy market, assisting those who cannot afford to buy, and reducing demand on government public housing.

Investor demand for property supports the building industry, creating employment.

Tax benefits encourage individuals to invest and save, especially to help them become self-sufficient in retirement.

Startup losses are accepted as deductions for business, and should also be accepted for investors, since investors will be taxed on the result.

Interest expenses deductible to the investor are income to the lender, so there's no loss of tax revenue (except to the extent their tax rates differ).

Opponents of negative gearing say,

It encourages overinvestment in residential property, an essentially "unproductive" asset, which is an economic distortion.

Investors inflate the residential property market, making it less affordable for first home buyers or other owner-occupiers.

In Australia in 2007, 9 out of 10 negatively geared properties are for existing dwellings, so the creation of rental supply comes almost entirely at the expense of displacing potential owner-occupiers.

It encourages speculators into the property market, inflating for instance the property bubble of 2003.

Tax deductions and overall benefits accrue to those who already have high incomes. (One can see from the rules above that the break-even point for those on high tax is less than the break-even for those on low tax, though obviously the latter then give up a lesser portion if they make an overall gain.)

Tax deductions reduce government revenue by a significant amount each year, which either represents non-investors subsidising investors, or makes the government less able to provide other programs.

A negatively geared property never generates net income, so losses should not be deductible. (Deductibility of for example business losses when there was a reasonable expectation of gaining income is well-accepted, the point against negative gearing is that it will never generate income. Opponents of full deductibility would presumably at least allow losses to be capitalized into the investor's cost base.)

It will be noted a couple of the points on each side are the same thing but interpreted differently. For instance support for the building industry is either an economic distortion or job creation, according to one's view. Like much about government policy in economics it's easy to focus on a particular group that one views as deserving or undeserving, to make a case for or against.

Nothing in gearing and its tax treatment is specific to property, so it may just as easily be said to encourage investment (or overinvestment) in any asset class. In practice however investor expectations create a preference for property. Property is considered by many to be a "sure thing" or almost so, ie. always stable or rising, so owning as much as possible is the aim, with cash to pay the loans the only limiting factor. Negative gearing looks like a way to have the tax man and a tenant help pay one's mortgage.

A certain amount of hype surrounds negative gearing, especially from those selling services to investors. Taxpayers on the top rate of 48.5% (for 2006, including the Medicare levy of 1.5%) are eager to hear of present tax benefits, and may merely assume future gains will follow. But it should be obvious that any strategy making initial losses will cost the investor after-tax money, which must be made up by future after-tax gains before it can be worthwhile.

[edit] Political Matters

In July 1985 the Hawke/Keating government quarantined negative gearing interest expenses (on new transactions), so interest could only be claimed against rental income, not other income. (Any excess could be carried forward for use in later years.)

The result was a considerable dampening of investor enthusiasm. The new capital gains tax shortly afterwards (September 1985) may have contributed too. With fewer landlords, rents rose. But house prices rose or continued to rise too, apparently because less new construction for investors kept the market tight (the factor of fewer investors competing with owner-occupiers to buy was apparently overwhelmed).

As of 1 July 1987 the present tax treatment was reinstated. The immediate effect however was only further house price rises as investors returned to the market before new construction could catch up.

The political result of this exercise was to put the subject of negative gearing practically off-limits to both major parties ever since. Neither wishes to be seen as contemplating any change to the system, for fear of what it may do to the rental market and/or the property market or building industry.