Australians have a love affair with real estate, and rightfully so.
It’s an asset that’s always in demand. It’s tangible, easy to understand, it offers proven returns, and you can use other people’s money to buy it. But all of those things are generally true about real estate in other countries.
So, what sets Australia apart?
In our country, real estate is taxed rather favorably. Our government has created tax concessions to purposefully steer investors toward buying homes, with the hope of meeting the housing need brought on by our ambitious goals for population growth.
While many countries offer some level of tax benefits to home buyers and investors, Australia is one of the only countries in the world, with New Zealand and Japan being the other two, that allows a negative gearing personal income offset.
In most countries, investors are only allowed to deduct losses against the income produced by the same asset class. In Australia, investors can carry an asset’s loss against all of their personal income.
This negative gearing benefit has encouraged real estate investment amongst the masses. No longer have investors needed to concern themselves with operating costs or cash flow. The tax offset has become the justification for the purchase. It has become an easy sell for property spruikers: “It’s okay that the property returns a loss; you’ll be able to keep more of your hard-earned cash at tax time.”
In part due to this mindset, buying real estate has become a rite of passage in our country.
What is Negative Gearing?
So, what is negative gearing?
Often proclaimed to be “a property investor’s best friend,” negative gearing is a concept that few people truly understand. As a result, the average person is left vulnerable to be taken advantage of, and many investors have experienced financial heartache as a result.
Property professionals have made a killing over the last decade selling negatively geared properties to unsuspecting investors. Sadly, many investors are sold on the potential outcome of making truckloads of money over time, without fully understanding the immediate consequences of their investment.
Negative gearing is a strategy that provides immediate tax benefits, while also offering the promise of long-term gains in the form of capital appreciation.
As Steve McKnight points out in “Positive Cash flow Returns Through Property Investment,” there are only two ways to make money in real estate:
Capital Appreciation: This is when your property increases in value.
Positive Cash Flow Returns: When the rental income is greater than all of the expenses of holding and renting out a property combined.
The sweet spot is when you can get both growth and positive cash flow at the same time, but with negative gearing, you’re restricted to only one way of making money, which is through capital growth.
Do you think this brings you more risk or less risk as the landlord? If you said “more risk,” you’re absolutely right.
Let me ask you the question this way: Would you rather have one or two ways of making money? I hope you’d say two. Why? There’s less risk. If one fails, at least you’ve got the other one as a backup.
If you own a positive cash flow property, even if that asset’s value remains stagnant for a decade, you’ve still made a profit each and every month.
With negative gearing, the government incentivizes you to accept more risk in return for paying less tax. The problem is, most investors don’t realize they’re accepting more risk. After all, where’s the risk when you believe real estate always goes up in value?
In a rapidly rising market, as we’ve seen in most of Australia over the last two decades, people tend to develop this optimistic mindset: Just hop on board, and allow the energy of the wave carry you to financial freedom.
We’ll talk more about the risks of negative gearing and the perma-bull mindset later. First, let’s delve deeper into the primary motivation of negatively geared investors – the tax benefits.
What are the Tax Benefits of Negative Gearing?
The Australian Taxation Office (ATO) allows property investors to offset the income loss of a rental property against any other personal income. A rental property loss occurs when the costs of owning and operating the asset are greater than the income it produces.
Let’s work through an example to illustrate.
John is a taxpayer who earns $120,000 per year. He just bought an investment property for $500,000, including closing costs.
To maximize his available tax deduction, he has been able to secure 90-percent financing on a 30-year interest only loan with a current variable interest rate of five percent per annum. He makes the weekly loan repayments in advance.
The developer has offered a five-year rental guarantee of $400 per week.
The rates and body corporate fees total $3,500 per year, plus he pays the property manager a fee totaling eight percent of the rent collected.
Let’s ignore any depreciation benefits for the time being. Here’s how John’s property investment stacks up at the end of the year:
· Rental Income
$20,800
· Management Fee
– $1,664
· Loan Interest
– $22,500
· Rates, etc.
$3,500
· Total
$6,864
John is then able to claim the loss of $6,864 against his personal salary income and reduce his overall tax bill as follows:
John with
no property
John with
one property
· Salary
$80,000
$80,000
· Property Tax Loss
–
($6,864)
· Taxable income
$80,000
$73,136
· Tax + Medicare
($19,147)
($16,779)
· Net income
$60,853
$56,357
John had to dip into his personal income in the amount of $6,864 throughout the year to keep his rental property afloat. In return, the government let him keep an extra $4,496 of his hard-earned money at tax time.
So, John paid out $6,864, only to get back $4,496. He’s still in the hole for $2,368 for the year. That’s nearly $200 per month.
Are you wondering why John would buy an asset guaranteed to lose him nearly $2,400 per year? That’s a good question, since the answers raise several key issues at the heart of negative gearing.
Here’s the short answer: John is gambling on the future direction of the market. He’s speculating that his annual capital gain will consistently be more than his annual income loss after his tax savings.
So, how much growth does John need per annum to break even?
$2,368 / $500,000 = 0.47 percent
That sounds reasonable. If John can get just half of one percent per year growth on his asset, he’ll at least break even.
Better yet, if he gets a growth of three percent per year for as long as he owns the property, he’ll add $12,632 to his net worth each and every year. Had John bought this property 15 years ago, he’d likely be sitting on a small gold mine today.
You might be thinking, “What’s the problem? Negative gearing sounds like a winning strategy to me. Surely I could average at least three percent per year over time.”
Is Negative Gearing a Winning Strategy?
Before you get too excited about negative gearing, let’s take a closer look at the difference between a realized gain and an unrealized gain.
Let’s say John achieves his three percent annual growth projection. Before factoring in his cash flow loss, that’s $15,000 in the first year. Over 10 years, that amounts to an unrealized gain of about $172,000. Not bad.
But, let’s say, after holding for 10 years, John sees the economic writing on the wall and believes the market will now move backwards. He decides to sell his property.
How much cash will he pocket? Well, there are some costs involved in selling real estate. Not only that, the government wants its slice of John’s capital gain. As if that wasn’t enough, whatever cash remains lacks the buying power it once had.
Let’s factor in sales costs, capital gains tax and the loss of buying power through inflation, to see how much better off John is for all of his aggravation as a landlord over the last 10 years.
We’ll assume that John finds a buyer for his property willing to pay $675,000. The agent’s sales commission is 3.3 percent. His cash flow losses after the tax offset total $30,000. The rate of inflation has been two percent per year.
Here’s what the numbers look like:
· Sales Price
$675,000
· Purchase Price
– $500,000
· Sales Costs
– $22,500
· Net Proceeds
· $152,500
· Capital Gains Tax*
– $22,875
· Net After-Tax Gain
$129,625
· Gross Income Loss
– $30,000
· Net Appreciation
$99,625
· Impact of Inflation**
– $109,497
· Real Growth
– $9,872
* CGT calculated assuming 30 percent marginal tax rate after CGT discount
** Inflation Impact: ($300,000 x (1 + 0.02)10) – $300,000
Yes, you read that correctly. After factoring in average annual inflation of two percent with an average annual growth rate of three percent, John actually decreased his real wealth.
How is that possible? His one-percent margin of capital growth above inflation was eaten up by sales costs and capital gains tax. This shows us that we need significantly more than three percent to gain any wealth creation traction through negative gearing. When considering the impact of inflation upon real wealth, timing the market becomes extremely important.
On a side note, back in the good ol’ days before the introduction of the CGT discount, investors were permitted to factor inflation into their profit before calculating CGT, so they didn’t have to pay tax on the inflation component of a capital gain.
This arrangement was ideal for investors during periods when property was growing only slightly more than inflation. However, under the current tax code, investors are better off when the margin between inflation and capital growth is wide, as we saw in Melbourne and Sydney from 2013 through 2015.
Is negative gearing a winning strategy?
That depends. If capital growth, inflation and tax laws work together to increase your real wealth over time, then yes, it can be a winning strategy. But if your asset does little more than keep pace with inflation, or if you can’t find a buyer for your property when you need to sell, then at best, you’ll go through a lot of aggravation for nothing. At worst, you could end up wishing you never heard of negative gearing.
To keep John’s example simple, we did not explore the depreciation benefits often promoted by negative gearing advocates. However, this is an important topic discussed by Steve McKnight in his investor briefing titled “Depreciation – Investor Delight or Extreme Danger?”
What are the Risks of Negative Gearing?
By now, your eyes should already be open to the risks of negative gearing.
Before John purchased his negatively geared property, he made some assumptions about the overall real estate market, future borrowing costs and his employment outlook. If you are negatively geared, whether you realize it or not, you have made these five key assumptions:
1. Capital growth will exceed operating losses.
As I mentioned before, with negative gearing, there’s only one way to make money, and that’s through capital growth. And as already demonstrated, you need more than just a marginal amount of capital growth to build real wealth.
If the negatively geared asset does not increase in value at least as much as the cash flow loss after the tax offset, then you are losing money each and every year. Without ever-increasing real estate values, you are doomed to failure without a negative gearing strategy.
Negative gearing is the ultimate form of property speculation based on the assumption a buyer will be available and willing to pay more than you paid – significantly more.
2. You can continue to fund the loss.
Negative gearing is a strategy that guarantees a cash flow loss. You enter the transaction with the knowledge you will need to dip into your personal cash flow in order to fund the loss.
The assumption is that you will always have a margin above your budgeted household expenses to meet the shortfall on the rental property, but that may not always be the case. Any number of things could happen to you that could narrow or remove that margin, such as:
Receiving a pay cut and being unable to find a better paying job.
Losing your job altogether and being unable to find a new one.
Increasing household expenses and/or property operating costs.
A family emergency with unexpected expenses.
Rising borrowing costs.
Losing a tenant and being unable to find a new one for an extended period.
Being forced to rent your property for a lower amount in the future.
For most people who have a reserve of savings, encountering one of these situations would not be catastrophic, but what if you were hit with two or three of them at the same time?
While we must not allow fear to paralyse us and render us inactive as investors, we must also be aware of our assumptions and the risk those assumptions will not play out like we had hoped. We mustn’t see the world through rose-colored glasses.
3. The government will not change the taxation regime.
One of the key assumptions of investors buying negatively geared properties is that the negative gearing tax offset will always exist, but there is no guarantee. The government could decide to take it away at any time.
This is exactly what happened in 1985 when Paul Keating was treasurer. To discourage property speculation at the expense of the government, Keating changed the law, deciding rental property losses would be quarantined and could only be claimed against rental income, not personal income, and with any excesses to be carried forward to offset profits in future years.
The property industry freaked out and began lobbying intensely. They pointed to higher rents in Sydney and Perth, claiming that the changes were increasing scarcity in the rental market and driving up rental prices. The government capitulated, and changed the law back.
There is much political discussion today about whether negative gearing should once again be scrapped. It’s likely that if there is a change, current owners of negatively geared properties would be grandfathered into the current tax law, but there is no guarantee.
How would you be impacted if the government abolished the negative gearing tax concession?
4. Interest rates will keep borrowing costs manageable.
When buying real estate, the greatest ongoing expense is interest on the mortgage. This is the primary expense that investors consider when weighing up the cost of owning a negatively geared property.
Most investors today have a limited understanding of the history of interest rates. We’re currently in an economic environment in which interest rates have been suppressed by central bankers, and are at the lowest levels in history.
This will not always be the case. Financial statistics tend to revert to their mean. In other words, over time, interest rates will tend to move toward their historical average.
The average standard variable home loan rate in Australia from 1990 to present is about 8.50 percent. That’s nearly double what some lenders are offering today. As recently as January 2009, mortgage rates were over nine percent.
Most investors would be in bad shape under these market conditions. The average homeowner would be forking out an additional $1,125 per month. That could be devastating for a negatively geared investor. At best, say goodbye to your beach holidays. At worst, say goodbye to your property, and your good credit.
5. Inflation will remain low.
A high rate of inflation can be a painful, double-edged sword for negatively geared investors.
First, higher living costs would impact your personal cash flow and leave fewer dollars available to keep your property afloat. If the situation got bad enough, you may need to decrease your standard of living or even sell your property. The problem you could face is a lot of other people would be in the same situation and trying to sell at the same time, too.
Second, as detailed above, high inflation is bad for investors who are trying to build wealth through real estate. At the end of the day, 15 percent per annum capital growth is of little benefit to an investor if the inflation rate is 12 percent.
In fact, it would be the same real wealth building outcome of an investor getting five percent per annum growth when the inflation rate is two percent. Either way, the margin is only three percent.
Negatively geared investors need capital growth to be high, but they also need inflation to be low.
How Does Negative Gearing Impact Home Prices?
The property market is currently being propped up, at least in part, by the tax benefits of negative gearing. If these benefits were taken away, a significant motivation for holding loss-making assets would be removed. Many would be motivated to sell and home prices would decline.
The government first allowed property investors to offset rental property losses against personal income back in the mid-1980’s when mortgage rates were approximately 12 percent. At that time, high borrowing costs kept many would-be investors out of the property race. Nonetheless, home prices shot up, and then they leveled back off until the mid-1990’s.
Then interest rates began to fall, removing a significant barrier of entry into the property market. Since 1996, home prices have been on a steady trajectory upward. The higher home prices have climbed, the more debt has been required to purchase rental properties.
But this is not a problem because, thanks to negative gearing tax benefits, making a profit from cash flow is no longer essential. You can justify the loss by writing off your losses against your personal income. As long as the banks keep lending and someone can buy from you later at a higher price, you win.
Negative gearing provides demand where otherwise it wouldn’t exist – the point at which the asset is no longer profitable from a cash flow perspective. The negative gearing tax benefit drives demand, which together with other factors increases home prices.
Keep in mind that the whole system hinges upon banks abilities to keep lending more and more, so home prices can remain high. If at any point new home buyers are unable or unwilling to borrow more than the previous owners, home prices will begin to fall.
What Kind of Borrower Are You?
The greater fool theory states that the price of an asset is ultimately determined, not by market fundamentals, but by irrational beliefs and expectations in the market. Home buyers purchase under the assumption that their asset can always be sold in the future to a “greater fool,” or someone willing to pay a higher price.
This premise is at the center of market cycle theory. The boom is over when the greatest fool buys. Once the greatest fool buys, the bust is imminent.
Hyman Minsky was an economist who warned about the dangers of being the greatest fool. Having earned a Ph.D. from Harvard, he taught economics at Washington University in St. Louis for over 25 years. Until the global financial crisis of 2007 to 2008, he was mostly ignored.
Minsky argued that the primary cause of a financial crisis is the accumulation of private debt. He explained this by identifying three different types of borrowers: hedge borrowers, speculative borrowers and Ponzi borrowers.
Hedge Borrowers
Hedge borrowers are the most conservative and efficient of the three. They can fully cover all debt repayments, both principal and interest, from the current cash flows of their investments. These are the real estate investors with principle plus interest loans on a positive or neutral cash flow property.
The rental income generated by the asset pays the borrowing costs and also reduces the debt. Rather than betting exclusively on future capital growth, these investors “hedge” against the risks of future serviceability and asset value depreciation by gradually reducing their debt exposure.
Speculative Borrowers
Speculative borrowers carry greater risk than hedge borrowers. The cash flow from their investments can service their debt, but exclusively on interest-only loans. Their investments don’t produce enough income to reduce the principal amount.
Speculative borrowers “speculate” primarily on capital growth, and secondarily on future serviceability. They are betting the asset will either be worth more at the time of sale, or they will be able to qualify for a loan to refinance the debt. This is the real estate investor who has sufficient cash flow to cover interest-only repayments on their property, but they never reduce the principal.
Ponzi Borrowers
Ponzi borrowers take their name from the Italian con artist, Charles Ponzi. He became famous for devising a moneymaking scheme in the 1920’s by paying early investors using the investments of later investors.
Ponzi borrowers don’t have enough cash flow from their investments to make interest or principal payments. They assume that income from other sources will be sufficient to make up for the cash flow shortfall, and that the appreciation in the value of the asset will be greater than the negative cash flow. In other words, there will be a “greater fool” to buy the asset in the future.
These are the real estate investors who are negatively geared. They carry the greatest risk and are the least efficient out of Minsky’s three different types of borrowers. Ponzi borrowers can only stay afloat through the perpetual appreciation of asset prices.
Minsky believed the inevitable fall of the Ponzi borrowers would eventually cause the financial system to collapse. When asset prices stop increasing, or worse, when the bubble bursts, the Ponzi borrowers begin defaulting. This can lead to a contagion that eventually takes out the speculative borrowers who can no longer roll over their debts. If the collapse is dramatic enough, the speculative borrowers could even take out the hedge borrowers.
Some economists, like Steve Keen, believe that the accumulation of private debt, spurred on by negative gearing, will eventually lead to a financial crisis here in Australia. Others dismiss such claims, pointing to the resilience of our property market through past economic shockwaves.
Will the Negative Gearing Benefit Be Around Forever?
As previously mentioned, a key assumption of negatively geared investors is that the government will not make significant changes to the current tax regime. While such changes seems unlikely, they are possible.
The tide of public opinion currently seems to be shifting away from a favorable view of negative gearing tax benefits. The younger generation, feeling frustrated by the high barrier of entry into the housing market, is increasingly blaming tax laws that seem to benefit only the wealthy.
In response, the Labor Party recently shocked the housing industry when it announced plans to limit negative gearing to new homes, and reduce the capital gains tax discount to 25 percent. Anyone buying after July 1, 2017 will be affected by the change. All previous purchases will be grandfathered under the current legislation.
We recently polled the Property Investing.com community to ask, “How would you be impacted as an investor if negative gearing on existing homes was scrapped?” The response from 23 percent was, “It would be devastating to my financial goals.”
If these laws were to change, there would be far-reaching and significant ramifications for property investors. If you want to delve deeper into what these changes may look like, read “What Investors Can Expect If Negative Gearing Gets Scrapped.”
The Seven Harsh Realities of Negative Gearing
Here are seven truths that summarize the dark side of negative gearing:
Negative gearing is a strategy guaranteed to lose money.
Buying a property based on depreciation benefits ignores reality.
The benefit of attracting premium benefits can be deceptive.
New homes are often sold using inaccurate growth comparisons.
Off-the-plan real estate is often priced to include a secret commission.
Investing to save tax is a dumb strategy.
Buying negative cash flow properties diminishes your buying power.
For a more thorough, in-depth explanation of each of these points, read the full article, “The 7 Harsh Realities of Negative Gearing.”
9 Questions You Should Always Ask Before Buying an Investment Property
Most people enter the real estate market with the assumption that all homes will inevitably increase in value. The dark side of the perpetual-growth assumption is that investors are inclined to rush out and indiscriminately buy any property that “feels good,” or that is recommended by someone who they perceive to be an authority.
Invariably, most of these investors end up with negatively geared properties, and in Hyman Minsky’s words are “Ponzi Borrowers.” Before you rush out and buy a rental property, ask yourself this series of key questions:
What’s the end goal?
Will buying this property bring me closer to, or push me further away from my goal?
Am I making money or just saving tax?
What will the annual cash flow be after deducting operating costs?
Can I afford to make a sustained loss?
What is my exit strategy if things get tough?
What must happen to make money on this deal?
How many of these properties could I afford to own?
Have I double-checked all the figures and sought independent verification of the data?
In the article, “9 Questions to Ask before Buying a Rental Property,” I go into detail on each of these nine questions.
By shifting your mindset, developing a strategy and using a thorough due diligence system for researching and assessing properties, you will be well on your way to avoiding the most common mistakes and pitfalls of less sophisticated investors.
Recommended Reading
Positive Cash Flow Returns Through Property Investment
What Investors Can Expect If Negative Gearing Gets Scrapped
The 7 Harsh Realities of Negative Gearing
9 Questions to Ask before Buying a Rental Property
What Type of Borrower Are You?
A Lesson From John Templeton on Market Cycles
Will the Australian Dream Lead Us Into a Debt Crisis?
The Ultimate Reason Real Estate is So Expensive
Do Positive Cash Flow Investment Properties Still Exist Today?
Depreciation – Investor Delight or Extreme Danger?
Post originally written by Steve Mcknight and was published on 12 Jan 2014. Updated extensively by Jason Staggers and republished on 14 Apr 2016.
The post The Ultimate Guide to Negative Gearing – The TRUTH! appeared first on PropertyInvesting.com.