Negative gearing for property investors makes good economic sense: Cameron Kusher
n its most simplistic form, negative gearing for investment housing allows investors to deduct their losses against their personal taxable income. These losses may occur when the investor incurs costs such as interest on a home loan as well as maintenance and other small expenses on an investment property. However, it is important to note that negative gearing is not unique to the property asset class; it also applies to businesses and shares in Australia.
The most important thing to realise about asset negative gearing is that it is fundamentally offsetting a loss. Although you can claim that loss on your tax return, the investor must carry the cost of that loss throughout the year. Ultimately, when investing, most purchasers would be hoping that rental rates increase over time and result in the asset moving from a loss-making one to an income-producing one.
It is also important to note that between September 1985 and September 1987, negative gearing laws were changed. The government quarantined negative gearing interest expenses on new transactions. As a result, investors could only claim interest expenses against rental income, not other income.
Given that negative gearing provides a benefit to investors, we look at the impact these changes had on the investment market over the two-year period. The first component is the impact the changes had on the rental market.
According to the rental component of CPI data, rents across the capital cities rose by 21.8% over the two years to September 1987 (the period during which negative gearing laws were changed). The increase in rents was most pronounced over the period in Sydney (26.1%) and Perth (31.1%). As a comparison, over the two years to September 1985, rental costs rose by a lower 17%.
The data clearly shows that rental growth was present over this period and it was greater than it was over the two-year period directly preceding it (The above chart shows the period for which the negative gearing rules were changed and are bolded black). Here you can see that rental growth was well above average, particularly recent averages, but it was not unprecedented, with rents growing by a greater amount on an annual basis in late 1982 and early 1983.
Another important determining factor is the demand from investors over this period. Unfortunately the Australian Bureau of Statistics does not provide information on the number of loans to investors; rather it provides the total value. The total value of investment finance commitments in September 1987 was 41.5% higher than in September 1985. These figures seem to suggest that at that time there was no weakness in demand for investment housing, however, a clearer outcome would be apparent based on the number of loans rather than the value.
The reason why negative gearing was reinstated in September 1987 was that it was proclaimed that rents rose sharply on the back of a fall in housing market investment. However, it doesn’t look as if investment in the housing market dried up throughout this period. Rents clearly did rise quite sharply throughout, as demonstrated.
Many in favour of removing negative gearing from property say that it should occur due to the fact that housing is an unproductive asset class.
My argument is that given that housing provides shelter, if investors don’t purchase these assets, it would then be the responsibility of the government to provide this shelter. Ultimately, that would mean that anyone that pays taxes would be funding housing for those who can’t afford it themselves.
One of the arguments against negative gearing is that the tax deductions afforded to investors in the housing market reduces government revenue. However, if investors did not provide shelter to those who can’t provide it to themselves, government revenue would already be reduced due to the fact that this responsibility would fall on the government.
If we look at the recent Australian Bureau of Statistics (ABS) dwelling approvals data, it is interesting to see just how much of the new housing supply is created by the private sector as opposed to the public (government) sector. According to the ABS dwelling approvals series, which began in July 1983, between July 1983 and October 2012, 4,355,266 dwelling approvals have been given to the private sector compared to just 228,843 to the public sector. Over the last 29 years (give or take a few months), public housing approvals have accounted for just 5% of all dwelling approvals. This is less than 8,000 approvals by the public sector each year!
Over the 12 months to October 2012, 145,515 dwellings approvals were granted to the private sector (98.6%) compared with just 2,065 to the public sector (1.4%).
The most recent census data shows us that of those homes occupied, 29.6% are rented (investment properties). Based on this data, if we assume that without the private sector building homes for investment purposes, the public sector would have to account for 29.6% of all dwelling approvals to cover those in rental accommodation. Over the past 12 months this would have equated to 43,684 dwelling approvals. If we also consider that the median home price across Australia as at October 2012 was $386,000, and if the government had to buy the land and build 43,684 homes, this would cost the Government of the day $16,861,900,480 based on the number of approvals and the median home price.
Of course this is a rather simplistic calculation and if the government were to build homes on its own land it would cost less, as that figure includes land and building. Also, it is unlikely that private investment in residential housing would cease without negative gearing but I would expect that it would fall.
The most recent taxation statistics data shows that over the 2009-10 financial year, $4.81 billion in net rental deductions were claimed by taxpayers.
In order for the government to break even to allowable deductibles from tax returns they would have to be building those 43,684 homes at a cost of $110,100. Based on the current median home price across the country at $386,000, they would have only been able to build 12,461 homes over the past 12 months or 8.4% of the total building approvals over the past year. It should be noted that not all new builds are for investment purposes but if we assume that 29.6% are there is a significant shortfall.
When you look at these figures it is obvious why negative gearing is unlikely to be removed. Whether the removal of negative gearing impacted investment or not, and whether it lead to an increase in rents is a secondary concern relative to how much it would cost the government to supply public housing for the almost 30% of Australians that don’t own their own home.
These figures are not to suggest that if in the case negative gearing was removed, there would be no investors in the market however, the appeal of negative gearing is part of what attracts many investors to the market. Without negative gearing it is likely that there would be fewer investors and therefore less private developers delivering new homes coupled with a greater need for the public sector to provide housing. The flow on effect may also be that there would likely be lower demand for housing credit. Although some proclaim removing negative gearing would cause house prices to fall, I would expect that new housing supply would be even tighter as developer’s struggle to achieve pre-sales for new development, this may in-turn force prices higher than they otherwise would be.
By looking into the figures in more detail, it makes good economic sense for the government to allow housing investors to negatively gear their properties so that the significantly greater cost of providing social housing is not borne by the Government and ultimately the Australian taxpayer.
Cameron Kusher is senior research analyst at RP Data.