Negative Gearing

Policy analysis by Professor John Freebairn, Department of Economics, University of Melbourne

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Key points

  • Labor proposes to restrict the use of “negative gearing” and to halve the discount on capital gains. This would probably result in slightly lower house prices and slightly higher rent
  • The Coalition proposes to retain the current system

Labor’s plan on negative gearing and capital gains

Labor proposes to limit negative gearing and to reduce the capital gains discount from July 2017.

  • Losses from the purchase of an established rental property will not be deductible against other income
  • No change for the purchase of new property
  • Current capital gains discount on rental property would be halved

For purchases of established property, any negative gearing sum will not be deductible against other income, including wages. But a negative sum or loss can be carried forward as a deduction against future rental property income. There will be no change for purchases of newly constructed rental property.

The delayed claim of the expenses is less valuable to the taxpayer.

The current capital gains discount on rental property, and on other household investments other than their own home, purchased after July 2017 is proposed to be reduced from 50 per cent to 25 per cent.

Together, the Labor proposed changes to negative gearing and the halved capital gains discount will increase the effective tax burden on new investments in rental property. The higher effective tax will be larger for established buildings than for new construction buildings.

Interestingly, the proposed reform increases the effective income tax burden on rental housing relative to the income tax burden on owner-occupied housing. In the case of owner occupied property there is no income tax on imputed rent or on capital gains.

The effects of Labor’s plan on house prices and quantities

  • Slightly lower house prices
  • Slightly higher rents
  • Some reallocation of the housing stock from rent property to owner occupied property

A higher effective tax rate on investment in rental property when combined with no change in the effective tax rates on owner occupied housing and other household investment options, in time will reduce investments in rental property and increase investments in the other options.  

The share of rental property in the aggregate owner-occupied plus rental property housing stock will fall. Some of the higher tax burden on rental property will be passed forward to renters as higher market rates of rent than otherwise to ration the reduced quantity of rental property. Given that occupiers of rental property are over represented among those on lower incomes, this effect is regressive.  

At the same time, the reallocation of some property from purchases for rent to owner-occupied use will push down the market price of houses, including owner-occupied houses. Some people will choose to transfer some of their wealth from rental property to investment in even bigger and better located owner-occupied housing.
Government would receive additional revenue.

While the above direction of effects of the higher effective income taxation of income earned on rental property are clear, the magnitudes of the effects are likely to be small.  

First, the changes apply only to property purchased after July 2017. Second, habits and conventions driving many household investment decisions, including the choice of investing in rental property versus other options, likely mean small decision responses to the changes in relative effective tax rates.

The current income taxation system of rental property which the Coalition will retain  

Different tax systems with different effective income tax rates are levied on capital income earned on investments in owner-occupied property, rent property, superannuation, financial deposits and shares.

In effect, there is no income taxation of owner-occupied property. Both imputed rent and capital gains on owner-occupied homes are exempt from income tax. At the same time, expenses of debt interest and for repairs and maintenance are not a deduction against income tax.

The income tax treatment of returns on investment in rental property is very different. Rent income less expenses on debt, repairs and maintenance, and other are taxable as accrued at the personal tax rate. If this sum is negative, as it is for many owners of rental property, the negative sum can be deducted against taxable labour income and other capital income. This is referred to as “negative gearing”.  

It should be noted that the deduction of expenses for rental property is normal income tax treatment as applied to other investments by households and businesses; also, lenders of debt borrowed for rental housing pay income tax on the interest income received.  

Realised capital gains on the sale of rental property, an important source of the income in recent decades, is subject to income tax, but with a 50 per cent discount. The combination of taxation of net income as accrued at the personal rate and taxation of capital gains at a half of the personal rate means the effective income tax rate on rental property is higher than that on owner occupied housing, but less than an income tax treatment.
Investment income received on savings invested in financial deposits and dividends received on shares are given a full income tax treatment. That is, these household investment options face higher effective income tax rates than rental property.

The Coalition proposes to retain the current hybrid system and different effective income tax rates on owner occupied homes, rental property, and other investment options. These differences distort household decisions with a loss of national income, and arguably they are inequitable. However, the proposed Labor reforms maintain these distortions and inequities, but with different details and magnitudes.  

Comprehensive reform of the income taxation of different household saving options still awaits us!

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