With all the fun and games in Canberra I thought we should reacquaint ourselves with a few of Labor’s tax policies. An election has to be held before the 18th May next year. This makes it seem a lot more likely that the Budget in May 2019, which is only 8 months away, will be a watershed moment for property.

 

Negative Gearing

Labor intends to change the tax laws so that investors can only claim a tax deduction against their primary income if they buy and rent out a new property rather than an existing property. For sake of definition – a new property is property that hasn’t been sold before. A builder builds a unit or new home, it is new property the first time it is sold. If that buyer resells it, it becomes an existing property.

If an investor buys an existing property, let’s say a 2 bedroom unit, the costs might look like this:

Under current law an investor on a 37% marginal tax rate would receive a tax refund of $3,293. With the new law they won’t. They would have to fund the loss themselves until the property was sufficiently paid off that it was making a profit. Once it’s making a profit then they could claim the previous year losses but that would take a while. To give you an idea, if rent and interest rates stayed the same, it would take about 16 years to get there.

The government estimates about $3 billion a year is being refunded to tax payers each year because of negative gearing claims. With the change in law, all existing arrangements will stay as they are so if you already own your investment property, things will stay as they are. It’s only new purchases of existing properties bought for investment that will be caught up in this deal. You may be thinking, okay then – I’m safe, but this will have repercussions.

Different groups of economists have looked at the figures and tried to work out what effect this tax change would have on property prices and rental amounts. None of them agree. The reasons for the disagreement seem to come down to whether they are left or right-winged in their thinking. How could I not jump into this muddy water and offer my own opinion?

Firstly, the policy proposal was presented as a way to help stop investors driving up the price of property and disadvantaging first home buyers. A noble cause, well supported by pretty much everyone. It’s the argument that Labor argued strongest. ‘We will stop upward pressure on property prices!’ Now that property prices are falling, how does everyone feel about the downward pressure on your property’s value being accelerated?

Labor could modify their argument to say that changes to negative gearing are intended to help make the real estate market more stable, less volatile and help first home buyers get into the market a bit easier. I would have to agree with them. I would also have to say ‘careful what you wish for’.

Investors make waves. They change demand so that when the market is climbing, they jump in to the real estate market and add to overall demand. And when demand is falling, they jump out of the market increasing supply and reducing demand. They accentuate the markets ups & downs making demand more volatile.
Without investors, the demand for existing housing stock would only come from owner occupiers and that demand curve is a flat as a tack as they say. The potential changes won’t eliminate investors completely but the lower the numbers, the lower the fluctuations. Investors will be able to claim depreciation on new property but that market is a mess. It has massive boom and bust cycles, is expensive to buy, expensive to rent for tenants and worst of all, the resale value falls for the first 7 years on average. An investor buying a brand new unit loses far more than they make and being given a tax deduction for your lost income at that point isn’t an advantage, it’s charity.

Older units have far more tenants wanting them because they are a lot cheaper to rent than new property. You can rent an older two bedroom unit for$400 per week. You want a new unit and its closer to $650. A lot of tenants can’t afford newer property. With older property no longer being bought by investors, it will mean less rental property in that part of the market.

Back in 1985, Federal Labor stopped negative gearing and by 1987 they were coping so much backlash from industry, State Governments (many who were Labor themselves) and the newspapers, that they had to reintroduce it. Those wonderful economists this time around have said that the backlash was political opportunism and the policy wasn’t a problem. They cite a whole lot of analysis of the market over the two years and say it wasn’t a problem. Truth is two years is too short to prove anything.

I was an agent then, and what I saw was investors selling at their normal speed. They sold to retire, to buy a home or because they wanted a different lifestyle. The problem was there were a lot less new investors buying. Rental stock was drying up and I witnessed rents rising, available property to rent ridiculously scarce and tenants scared, really scared. Every time an investor sold, the tenant would have to move out and look for another property to rent. A wave of rental enquiry was coming from the east. People from Lane Cove, North Shore and Inner West were all looking in our area because they couldn’t find property in theirs. Our tenants were being priced out. Vacancy was down to less than 1%. The NSW Labor State Government said that there was no way public housing could cover the shortfall in rental stock as a result of investors not buying property to rent out. Everyone was getting stuck into the Federal Government and in just two years, they reversed the tax law.

You’ll see the same thing again.

Even if you are not an investor, these changes will affect you. If you own a unit, you are going to feel the difference pretty much straight away. In most older, strata titled property, investors make up close to 50% of owners. In the case of townhouses and villas, it’s closer to 35%. Those percentages have remained stable for well over 40 years. When a unit comes on the market, half the buyers are usually investors. Often the buyers are first home buyers but need to rent the property out to help them afford it. These buyers will disappear overnight. And you can’t lose half the market demand for property and not have a fall in prices, which we have aleady started to see thanks to new tightened borrowing conditions.

The existing unit market (as opposed to the new unit market) is the incubator for the house market. If a person has to sell their unit for less, they will have to buy their house for less. Simple.

I watched the debate about abolishing negative gearing when Labor announced it a year or so ago. I listened to the many economists saying that there were no negative effects when negative gearing was abolished previously between 1985 and 1987.

They all feel so confident because they think numbers don’t lie. I didn’t write about the policy at the time because I thought it was a few years away and things can change in politics (boy, got that one right). As you can probably tell, my silence wasn’t agreement.

Truth is I guess you had to be there. I remember 1985. It was the start of a real estate growth cycle. This was the time of Christopher Skase, Alan Bond, winning the Americas Cup and the idea we could all be rich using debt. Back then to fund something that wasn’t cashflow positive was easier, you just had to borrow more. Banks would happily do that to help you. Between 1985 and 1989 we saw values increase by close to 100%. That isn’t the case now. The factors driving that market and the ones driving this market are so different that nothing will be the same. In my last newsletter I said that there were fundamental changes to the real estate market because of the Banking Royal Commission, investors and owner occupiers have a lot more trouble borrowing money. Unless you have bought recently and had to get a loan, you have no idea. People who have a lot of assets are getting rejected and can’t believe it. Now with this negative gearing change, banks will be even harder on investors. Investors will have to be able to fund the negative cashflow out of after tax earnings not before tax earnings. I’ll say it again, nothing is the same and this property downturn will be worsened by the changes to negative gearing.

Capital Gains Tax

This is part of the same policy strategy as negative gearing. It will almost certainly be changed. Again, they will grandfather the change meaning that it will only apply for property purchases after a certain date. For property you own now, nothing will change. If I had to choose which policy I would rather be introduced, it’s this one. Capital Gains tax hits you when you are selling and have made a profit. Removing negative gearing hits you when you are starting out, before any profit, before you have cashflow.

Right now, if you earn a dollar in capital gains only 50 cents is taxable and the other 50 cents is tax free. The tax free proportion is going to drop for new investors to 30 cents in the dollar. Without explaining marginal tax rates and the Medicare levy, any new investor will pay about 10% more tax when they sell. With negative gearing changes, the government over the long term won’t make any extra money. People will be able to claim those losses when they finally sell the property. Net effect to the government tax will be zero.

I expect Labor to win the next election. Will they change negative gearing? Probably. Will they change it back like Paul Keating, who was far more confident and eloquent and strong willed than our current politicians? Good question! He got rolled by reality. Let’s see what happens.

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