How is negative gearing a good thing?

Question

In Australia investors buy investment properties that are negatively geared to save tax. A lot of articles on property investment say that one of the cons of having a positively geared property is you cannot claim tax deductions.

For instance john's property is worth 100K. Adding expenses and interest comes at 10K a year and rent is only 7K a year so John is making a loss of 3K annually. If he is taxed at 45% he can claim deductions on his income and save 45% * 3K = $ 1350 But he still incurs an actual loss of 3000-1350= $1650 Negatively gear = 1650 loss

Conversely if John buys a positively geared property he will not be able to save the $1350 on his tax. But that's because he saves the other $1650 of his income AND make profit from the rent - interest. positively gear = 1650 + other profit

Of course the losses from negatively geared can be covered when the property appreciates. But positively geared properties appreciate too without making any loss. Why would someone want to pay less tax by having less income. Can someone please explain what I have missed?

Answer 1

It's not JUST about tax, it's more about tax timing tax deferral, good investment strategy and value.

1. A property (or any investment) has to be value for money right? But it doesn't have to be value for money right now. A property that is going to make a loss initially is presumably one that needs investment, and as such it should be for sale at a discount. Market forces mean that the discount should reflect the amount of money that needs to be spent on it, so in practise, the income loss should be appropriately offset, and if tax efficiency is improved, then it's a win.

2. As we know, tax is not linear, the more you earn the disproportionately high your tax is. A tax payer who is going to pay a lot of tax (this year, next year, whatever time scale is being worked to) at the higher levels because of a high level of income, who doesn't really need that income, at least not right now, COULD create more costs (if they pay back long term) and thus reduce tax, or invest in a negatively geared property. This will have the effect of smoothing out and/or deferring a relatively high tax (and thus low tax efficient) period. Of course, as you say, there's no point if there's no pay back in the medium or long term.

Also, if you think about it, if you can make money in the future buy investing now, and that investment is serving to improve tax efficiency now, you are actually investing the tax you would have paid and making money out of it! This is not a terrible thing for the tax collector (at least in theory) because long term the tax revenue should still be greater (so in effect the tax collector is invested as well).

Also, any property that is in need of investment will attract less buyers, and the more investment required the fewer buyers will be interested. At the extreme end you have properties that are more of less a write off (being sold off my mortgage lenders and insurance companies for example, after fire damage, evidence of subsidence, etc) and for these properties you can't even get mortgages, so the only eligible buyers are the ones with enough cash not only to buy it but also deal with all the problems.

Basic supply and demand means less buyers means less competition and less price. In practise the discount should be quite disproportionate to the investment required because or the extra risk, and thus more negative the gearing the more opportunity for long term gain there should be.

All this presumes you don't buy badly of course!

Not forgetting too of course that you using the lenders money to leverage and propel growth and future income.

Here's an example of how the tax collector discounts your investment.

Imagine your income is 100K. Let's say tax is 0% from 0-30K, 20% from 30K to 60K, and 50% 60K up. This means you are going to pay 26K tax and achieve 74K net income (26% tax).

If you now have a property that makes a loss of 20K, you pay 16K tax instead, 10K less (now 17.5% tax) and achieve 64K net income.

Let's assume the property loses this income for one year only. If you assume that the property is fair value considering the loss it is attracting short term, then the actual loss of income 20K has been invested, but your net income has reduced by only 10K.

Of course later, the property might become profitable, either because revenue is greater than cost, or because there is a balance sheet accounting profit due to appreciation, and thus your income might now be 150K (net 99K). The point is you've invested 20K, whilst losing only 10K of net income, and now you're better off. The tax collector is better off too (as your tax bill is now 51K), and the lender has your loan interest. Everyone's happy you borrowed that money and took that risk. Incentive to do it of course is greater the more (percentage wise) tax you pay.

One final thing, just in case it's not obvious, and this does depend on the tax regime of the country so might not apply to everyone, and I know you explicitly noted in your question that you understand the property can appreciate and offset the loss in the long run, but, that capital gain may be taxed at a lower rate to your income tax, thus if you give away money from income tax and get back the same amount as a capital gain, thus may give you a direct tax advantage for that reason. You're still spending short term and reducing short term net income in favour of future income though, and there's never any guarantee a property will appreciate of course for that matter, but it's perhaps something that should be mentioned as part of a complete answer.

Answer 2

You are correct that in many cases people who negative gear their investment properties are not better off.

The whole point of negative gearing was to give incentive to investors to purchase investment properties in order to increase the supply of rental properties, thus reducing the rate of rent increases. It was also meant to make investments that might have been somewhat financially unfeasible to ones that could become more feasible. And the properties it works best on are those that are negative geared only for the first couple of years before they become cashflow neutral or positive, and have good long term capital growth. It would aslo be more beneficial to investors on higher incomes in higher tax brackets.

The problem with negative gearing occurs when accountants and property spruekers started promoting it to their clients on low incomes and tax brackets on the sole basis of using negative gearing to lower their taxes.

Accountants see it as an easy way to reduce the tax of their clients without assessing the financial viability of the actual investment. Property pruekers see it as a good way of promoting and offloading their otherwise overpriced and unaffordable properties.

I have heard of many first time property investors, some of them friends, struggling to pay for thier investment property years after they bought it. When asked why did you buy it and why do you still keep it if you are loosing so much money on it? The respose is: because I am negative gearing it so I am paying less tax. They have been duped that it is ok to keep loosing money every week, every month, every year, because they can save a fraction of the money they lose on the tax they pay.

Negative gearing an investment property can be a good strategy for the right property and the right investor, however, it has been promoted on many properties and many investors who are not suitable for the strategy. If you are investing for the sole purpose of reducing your tax, then you are most probably investing for the wrong reasons and probably investing in the wrong property.

Just as a side note, negative gearing is not only available for investment properties, it is available for any type on investment where the costs of holding the investment are higher than the income from the investment. If you buy shares on a margin loan and the interest on the margin loan is higher than the dividends received from the shares, you can negative gear the shares to reduce your tax bill just as with a negatively geared investment property. As always the long term viability of the investment should be the reason for the investment. Negative gearing should never be the reason for anyone to make an investment, because if it is you will most probable end up loosing money over the life of the investment.