Negative gearing

Resource Wikipedia – negative gearing

Negative gearing is a practice whereby an investor borrows money to acquire an income- producing investment property and expects the gross income generated by the investment, at least in the short term, to be less than the cost of owning and managing the investment, including depreciation and interest charged on the loan (but excluding capital repayments).

The arrangement is a form of financial leverage. The investor may enter into such an arrangement and expect the tax benefits (if any) and the capital gain on the investment, when the investment is ultimately disposed of, to exceed the accumulated losses of holding the investment.

Tax treatment of negative gearing would be a factor that the investor would take into account in entering into the arrangement, which may generate additional benefits to the investor in the form of tax benefits if the loss on a negatively geared investment is tax-deductible against the investor’s other taxable income and if the capital gain on the sale is given a favourable tax treatment. Some countries, including Australia, Japan and New Zealand allow unrestricted use of negative gearing losses to offset income from other sources. Several other OECD countries, including the US, Germany, Sweden, and France, allow loss offsetting with some restrictions. Applying tax deductions from negatively geared investment housing to other income is not permitted in the UK or the Netherlands. Another example of is borrowing to purchase shares whose dividends fall short of interest costs. A common type of loan to finance such a transaction is called a margin loan. The tax treatment may or may not be the same.

A negative gearing strategy makes a profit under any of the following circumstances:

• if the asset rises in value so that the capital gain  is more than the sum of the ongoing losses over the life of the investment
• if the income stream rises to become greater than the cost of interest (the investment becomes positively geared)
• if the interest cost falls because of lower interest rates or paying down the principal of the loan (again, making the investment positively geared)

The investor must be able to fund any shortfall until the asset is sold or until the investment becomes positively geared (income > interest). The different tax treatment of planned ongoing losses and possible future capital gains affects the investor’s final return and leads to a situation in countries that tax capital gains at a lower rate than income. In those countries, it is possible for an investor to make a loss overall before taxation but a small gain after taxpayer subsidies.

Deduction of negative gearing losses on property against income from other sources is permitted in several countries, including Canada, Australia and New Zealand. A negatively-geared investment property will generally remain negatively geared for several years, when the rental income will have increased with inflation to the point that the investment is positively geared (the rental income is greater than the interest cost).

Taxation

Australian tax treatment of negative gearing is as follows:

• Interest on an investment loan for an income producing purpose is fully deductible if the income falls short of the interest payable. The shortfall can be deducted for tax purposes from income from other sources, such as the wage or salary income of the investor.
• 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 they are 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 1997 or certain other dates) attract a 2.5% per annum capital works deduction (or 4% in certain circumstances). The percentage is calculated on the initial cost (or an estimate thereof) and can be claimed until the cost of the works has been completely recovered. The investor’s cost base for capital gains tax purposes is reduced by the amount claimed.
• On sale, or most other methods of transfer of ownership, capital gains tax is payable on the proceeds minus cost base (excluding items treated as plant above).A net capital gain is taxed as income, but if the asset was held for one year or more, the gain is first discounted by 50% for an individual, or a third for a superannuation fund. (The discount began in 1999, prior to which an indexing of costs and a stretching of marginal rates applied instead.)

The tax treatment of negative gearing and capital gains may benefit investors in a number of ways, including:

• Losses are deductible in the financial year they are incurred and provide nearly immediate benefit.
• Capital gains (link to this topic in FAQ) are taxed in the financial year when a transfer of ownership occurs (or other less common triggering event), which may be many years after the initial deductions.
• If it is held for more than twelve months, only 50% of the capital gain is taxable.
• Transfer of ownership may be deliberately timed to occur in a year in which the investor is subject to a lower marginal tax rate, reducing the applicable capital gains tax rate compared to the tax rate saved by the initial deductions.

However, in certain situations the tax rate applied to the capital gain may be higher than the rate of tax saving because of initial deductions such as for investors who have a low marginal tax rate while they make deductions but a high marginal rate in the year the capital gain is realised.

In contrast, the tax treatment of real estate by owner-occupiers differs from investment properties. Mortgage interest and upkeep expenses on a private property are not deductible, but any capital gain (or loss) made on disposal of a primary residence is tax-free. (Special rules apply on a change from private use to renting or vice versa and for what is considered a main residence.)

Arguments for and against

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

• 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.
• Start up 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 by the investor are income for the lender so there is no loss of tax revenue.
• Negatively-geared properties are running at an actual loss to the investor. Even though the loss may be used to reduce tax, the investor is still in a net worse position compared to not owning the property. The investor is expecting to make a profit only on the capital gain when the property is sold; only then, the treatment of the income is favoured by the tax system since the only half of the capital gain is assessed as taxable income if the investment is held for at least 12 months (before 2000–2001, only the real value of the capital gain was taxed, which had a similar effect). From that perspective, distortions are generated by the 50% discount on capital gains income for income tax purposes, not negative gearing.

For more information Wikipedia – negative gearing