Low interest rates take the zing out of negative gearing

Ever lower interest rates have diminished the attraction of negative gearing.

As the debate rages over whether negative gearing — a tax efficient borrowing arrangement used by more than 1 million people — should be scrapped, the issue for investors is whether it actually works any longer?

New figures released this week by the ATO shine a light on the nub of the issue: negative gearing was a great arrangement when rates were high. Today we have the opposite scenario and negative gearing in most cases offers the most minimal of tax breaks.

This has three important outcomes:

1. From an individual investor’s perspective negative gearing in residential property means having to take increasing levels of risk with big amounts of capital to get decreasing rewards.

2. From a macro perspective it means risk is going to become elevated in the market as people stretch themselves further to get tax deductions. Put simply, where once the financing of a single modest apartment would provide a healthy tax deduction, now investors have to buy higher priced units or several units to get meaningful deductions.

3. From a political perspective it means if you are going to scrap or amend negative gearing rules, there has rarely been a better time to do it.

The latest ATO figures show that for all the attention around negative gearing as an inequitable tax break, the dollar cost of negative gearing fell by a whopping 30 per cent — or $2.4 billion — even though the number of people estimated to be involved in negative gearing lifted by another 60,000. And you must remember these figures are for the year that ended in June 2013.

So what has been happening? To recap: negative gearing is where you can get a tax deduction on the cost of financing an asset, typically a residential property. If you spend more each year on managing the property (including the cost of interest payments) than you get in rent — that excess amount is tax deductible against your total income.

But the tax deductions people are getting from negative gearing are simply shrinking — and the reducing attractions of negative gearing would only have accelerated since the ATO report came out as rates have been progressively cut to 2.25 per cent. For the average investor the numbers might read like this: with official rates at 2.25 per cent a mortgage rate might be about 5 per cent. In turn the rental yield on an average property may be somewhere around 4 per cent. As a result there is only 1 per cent in the difference. Even five years ago rates were considerably higher and the excess amount which is the tax deductible part of the arrangement was much bigger. Today it is tiny.

If the RBA cuts rates again on Tuesday then the tax deductibility gets slimmer still and the whole enterprise becomes ever more speculative.

What’s more the shrinking of negative gearing means that the average investor will become more dependent on the need to make a profit when it comes to capital gains. A poor negative gearing arrangement demands a substantial profit on the final sale of the property — otherwise the investor has wasted their effort.

Now it is much too early to say that residential property prices have had their run but in the last fortnight there have been two negatives any property investor — especially those considering entering the market now — must consider carefully.

● There are early signs of a softening in prices in the most overheated sections of the market. Most notably the inner-city Melbourne apartment market where there are a record number of buildings both under construction and approved for construction. Quarterly figures for the three months ending March 31 declined slightly in Melbourne, Brisbane and Canberra. Separately, the RBA has specifically warned buyers to take exceptional care with Sydney’s surging residential prices.

● Meanwhile, inside the property industry a consensus that the current housing shortage will last for many years has been punctured by investment bank Goldman Sachs, which has ruffled quite a few feathers with an estimate that we will have a surplus of 70,000 houses as early as 2017.

No wonder the debate around negative gearing is gathering steam. A recent Australia Institute report highlighting that wealthy Australians get the most benefits from negative gearing tax breaks has hit a nerve. It’s a mathematical certainty, just like it’s a certainty they pay the most tax (in terms of total dollars), they have the biggest cars or the most expensive garden furniture. Of greater interest was the revelation that the vast majority of negative gearing activity is linked with existing housing stock.

So at its worst negative gearing — which barely works with what RBA governor Glenn Stevens calls the lowest rates “in human history” — does precious little for the housing market and less for tax revenue.

At the same time it entices people to take on greater volumes of debt to offset the dissolving levels of tax deductions negative gearing offers.

Against this backdrop we get the chief executive of mortgage insurer QBE LMI, Jenny Boddington, suggesting “we’re comfortable that under the right circumstances there’s nothing wrong with lending at 95 per cent”. Or to put that the other way around, there’s nothing wrong with giving somebody the keys to a million-dollar property when they have a deposit of $50,000.

With a soft patch in house prices, sinking interest rates and a greatly weakened negative gearing scenario the “right circumstances” would have to be getting very rare indeed.

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