PolicyCheck: Negative gearing reform

Consequently, while not the only reason for increasing house prices and affordability issues in some locations, negative gearing has become a focal point in an election year for tax reform debate and a review of housing policy.

From Waleed Aly to the prime minister on his own blog, negative gearing is generating much talk without context.

Where does the idea come from?

Gearing describes the use of borrowing to finance an investment. When the interest costs of servicing that borrowing exceed the net income of the investment, it is said to be negatively geared.

The idea underlying negative gearing is relatively straightforward: when an individual (or business) incurs costs associated with generating income, those costs are tax-deductiblefrom income.

As it is applied to investment properties in Australia, when interest costs of the mortgage exceed the net rental income of the property (that is, it is negatively geared) then the net loss on the investment property may be used by an individual to offset their ordinary wage income.

This is because, under the current rules in Australia, investment property losses are not “quarantined”. That is, the losses on an investment property are not only tax-deductible against the income from the investment property. As a result, the higher your total income, the greater the tax-minimisation benefit of negative gearing.

Quarantining losses is a major point of difference in the application of negative gearing in Australia to the rest of the world, and a key area that previous reforms in Australia have targeted.

International examples

Compared to the rest of the world, Australia’s negative gearing policy is one of the most generous to property investors.

Of OECD countries, New Zealand and Japan have the most similar treatment of negative gains to Australia. In these countries, negative gearing is allowed with relatively few restrictions.

On the other hand, the United Kingdom applies strict quarantining rules to loss-making properties. Investment property losses may be applied to the pool of income from investment properties and carried forward, but the losses may not be deducted against wages (i.e. non-passive income).

However, this summary should be treated with extreme caution. An international comparison of negative gearing treatment is incomplete without also examining the rules for capital gains and other housing market distinctions such as owner-occupier versus investment properties and new versus existing developments.

In the United States, while not a system to aspire to, even interest on owner-occupied housing is fully tax-deductible against ordinary income. By contrast, in Sweden, tax deductions from negative gearing of rental properties are permitted (although quarantined with income from other capital assets), but imputed rents from owner-occupied housing are taxed.

The net welfare gains are cumbersome to measure and entwined with government policy.

Danika Wright is a Lecturer in Finance at the University of Sydney. This article was originally published in The Conversation.