Tax reform spotlight turns to capital gains on property

Opposition to both the capital gains treatment of property and allowance of negative gearing has reached a crescendo.

High-rise apartment blocks at Bondi Junction in Sydney’s eastern suburbs. Picture: Craig Wilson

Any investor with interests in residential property needs to be across the changing debate on tax breaks: opposition to the capital gains treatment of property and allowance of negative gearing has reached a crescendo, with the Reserve Bank openly criticising the tax regime this week.

Calls for changes to how investors can benefit from both the financing of property and, importantly, the selling of property are widespread. Cries of “foul” are coming from every conceivable corner, including unlikely sources: ANZ Bank chief executive Mike Smith, for example.

Put simply, the argument goes that the favourable treatment of residential property investment excludes first-home buyers, hampers the building of new homes and encourages speculation. And, of course, all of those criticisms are absolutely true.

Joe Hockey has responded with typical bluster and lack of clarity to this rising tide of angst over stronger house prices, suggesting the government will not make changes to negative gearing (the ability to claim any loss you make on running an investment property against your taxable income).

The Treasurer offers three key lines of defence for his position:

● The principle behind negative gearing is sound — the owners of assets should be able to write off expenses in their wealth-building activities.

● Negative gearing is not just for property, it can be used for other assets as well, such as shares.

● Most of those 1.3 million investors negatively gearing property are not rich; 900,000 of them declare an income of less than $80,000 a year.

Meanwhile, the economy finds itself heavily dependent on the building industry — particularly apartment building at this stage in the cycle. In turn that means state governments are dependent on stamp duty and a huge swathe of economic activity from builders to home furnishers to mortgage sellers will be jeopardised if the hottest part of the economy is rattled in any way.

From an investment point of view the story is quite different. The outstanding issue here is: what are the terms you can purchase or sell property? And will rentals and prices move higher in a reliable manner?

Certainly, the Treasurer’s argument that negative gearing is a principle matters very little — the tax system is awash with exceptions to principles and changing the tax treatment around residential property would hardly be unprecedented. The Keating government attempted but ultimately failed to change the negative gearing regime, while in Britain just last week the Conservative government severely cut back the tax advantages of its version of negative gearing.

As for the fact share investors also may negatively gear shares, this argument is of greatly diminished significance since the volume of share investors who “gear” has substantially evaporated since the GFC.

Separately, the argument that a large number of people “gear” property and most of them are not rich is surely a political issue rather than an economic point. Just now the truth is that even if more than a million people engage in negatively gearing property, it has rarely been such a poor proposition. The rock-bottom mortgage rates of less than 5 per cent mean that for most people there is precious little expenses to claim against their salary.

In the residential property market under these conditions it’s not about rental income or negative gearing, it’s about capital appreciation. Rentals are going nowhere. Despite rising prices in many cities, rental yields are stuck between 3 per cent in the middle of the larger cities to 4.5 per cent in regional areas. What’s more, there is evidence that rents are not just flat but falling: the SQM Research weekly rental report for the week ending July 12 shows a year-on-year drop in rental yields in Perth and Darwin with signals of softness on a monthly basis in every city except Sydney and Brisbane.

If the money being made in residential property is from capital appreciation then the tax that matters most to property investors is not the allowances of negative gearing but the framework for capital gains tax. (Investors must pay CGT on the sale of properties, but if they hold the property for more than a year the tax is halved.) In other words, capital gains is the sweet spot for tax purposes on property profits.

So it’s not the RBA’s statement on negative gearing that should worry property investors as much as its observation that Australia’s tax system is “relatively generous to small investors” because capital gains are taxed at concessional rates.

And though Hockey has explicitly ruled out changes to negative gearing, on capital gains tax he has said only that he would be “reluctant” to change anything ... the spotlight surely turns to CGT.

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