Negative gearing could be putting the Australian financial system at risk: Murray inquiry

The current tax treatment of investment property losses, through a combination of negative gearing and capital gains tax, has come under fire for putting the financial system at risk, according to the federal government’s Financial System Inquiry interim report.

Currently, negative gearing means that interest costs and other property expenses are fully tax deductible, while capital gains tax on properties is applied with a 50% discount.

The Financial System Inquiry, headed up by David Murray, states in its interim report that these arrangements “encourage leveraged and speculative investment — particularly in housing”.

“Because of these tax arrangements, owners of residential property have an incentive to repay their mortgage as slowly as possible to maximise the tax deductions they can accrue,” says the report.

“Loans with interest-only periods help to maximise these tax deductions in the early years of a loan, although these loans also give borrowers more flexibility with repayments. The tax system, therefore, encourages individuals to take on more risk, which does have implications for risks to lenders.”

Aside from negative gearing and the asymmetric tax treatment, the report identifies additional tax-related factors that are also distorting the housing market.

“In addition to the more favourable tax treatment, individuals have an extra incentive to put more of their wealth into their primary residence because of the means test for the age pension, which excludes the primary home. This leads to higher allocation of wealth to housing and, for some, an inefficient level of consumption of housing services,” the interim report states.

Current arrangements also mean family homes are a key savings vehicle for many Australians.

“Returns on owner-occupied housing (including imputed rent and capital gains) are exempt from tax, although this is not unusual by international standards. This makes housing a very attractive vehicle for savings,” the report states.

The favourable tax treatment for property investment has created a situation of increasing mortgage indebtedness, which in turn has created risks for the financial system.

“Since the Wallis Inquiry, the increase in households’ mortgage indebtedness has been accompanied by banks allocating a greater proportion of their loan book to mortgages; the share of loans for housing has increased from 47% in 1997 to its current share of 66%,” says the report.

“A large enough disruption to the housing market could have significant implications for household balance sheets, financial stability, economic growth, and the speed of recovery in household spending and broader economic activity following a shock.”

Mark Chapman, head of tax with lobby group Taxpayers Australia, told SmartCompany the report is correct in identifying that tax deductions people claim over the life of a property are greater than the losses they claim at the end.

“For high income earners, it’s an astute way to reduce their tax rate. But 70% of those using negative gearing are not high income earners, and are required to buy an asset to get a tax deduction,” Chapman says.

“It needs to be reformed. From a tax policy perspective, [negative gearing in its current form] makes little sense. In most jurisdictions, offsets for losses on property investments can only be claimed against profits on other properties, or be carried forward against future profits.”

Philip Soos, a research Masters candidate at the School of Management at Deakin University specialising in property tax law, told SmartCompany that since 2001, most investment property rents have not been high enough to cover interest and expenses.

“Around 60% of investor loans are interest only. It’s a big leverage bet on a capital gain – as long as wages are high enough to sustain the rents,” Soos says.

“While the argument is that it encourages new property development, around 96% of all investment property loans by value are spent on existing properties.”

“Abolishing negative gearing would be better than reform, but that’s unlikely, so quarantining it or reforming it so it’s limited to new, rather than existing properties, is probably the best option,” says Soos.

Brian Chant, managing director of Property Asset Planning, told SmartCompany negative gearing has some important benefits when applied to new properties.

“I think it’s very effective when used on brand new property. It allows you to turn over the economy, and when you turn over the economy, you employ people. It allows you to build new homes and new affordable housing,” Chant says.

“It needs to be reviewed and discussed further, but when it’s applied to new homes, it’s brilliant.”

However, Property Tax Specialists’ Shukri Barbara told SmartCompany reforming negative gearing too quickly could create its own risks.

“One important issue is the banks, who lend up to 90%, are heavily dependent on negative gearing. If you remove it too quickly, the values will drop and create the risk that people will sell their properties for less than they owe on their mortgages,” he says.