What is negative gearing and what is it doing to housing affordability?

This article is part of The Conversation’s series examining the housing crisis. Read the other articles in the series here.

Australia’s housing crisis is putting the Australian dream to own one’s home out of reach for many.

But it’s not just home ownership that has been affected. Rental affordability has also become a serious issue. This has reignited the debate about negative gearing; whether or not it is fair and whether it holds the key to fixing the housing crisis.

What is negative gearing?

Negative gearing refers to using borrowed money to invest in an asset so it results in a loss which can be claimed as a tax deduction against other income. For example, a property investment is negatively geared if the net rental income received is lower than the mortgage interest. The loss is then offset against other income, such as wages and salaries, which reduces the amount of income tax payable.

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Negative gearing is commonly used for property investments but also applies to other investments (such as shares). Investments can also be positively geared when net income from the investment is more than the interest on borrowings.

The attractiveness of negative gearing in Australia is mainly due to its ability to reduce the amount of income tax. For this reason, it can be more beneficial to individuals who are on higher marginal tax rates. However, capital gains tax must be paid on any gain when the asset is sold.

How does negative gearing work?

Let’s look at a simple example of negative gearing. Say an investment property was rented to tenants at A$500 a week ($26,000 a year), and associated expenses (such as agent fees, rates, mortgage interest, maintenance) were $40,000 for the year. This leaves a shortfall of $14,000.

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The property owner can deduct the $14,000 from their taxable income to reduce their liability. For example if they received $100,000 from wages, they would pay tax on only $86,000 (saving $4,550 in income tax). Individuals on higher incomes and therefore higher marginal tax rates would receive larger tax deductions (for example, someone earning over $180,001 would pay $6,300 less tax).

While negative gearing an investment property can reduce tax while it is being rented, it can also result in a large capital gains tax bill once the property is sold (even though capital gains tax is halved for assets held for more than 12 months).

For example, if the cost base for a property purchased ten years ago was $400,000 and it sells for $900,000 today, capital gains tax would be calculated on half of the $500,000 difference. At a marginal rate of 45%, the tax bill would be $112,500.

How widespread is it in Australia?

According to the Australian Taxation Office, about 2.25 million individual tax payers (21% of all individual tax payers) claimed deductions against rental income for a total 3.25 million properties in 2020-21 financial year.

Of these, 47% negatively geared their properties, claiming a net rental loss. This is equivalent to just less than 10% of all taxpayers. Investors with fewer properties were more likely to be using negative gearing with over 71% of property investors having only one investment property.

The largest group of property investors (524,220) had one investment property and a total annual taxable income between $50,001 and $100,000. The chart above shows the proportion of property investors by age group.

From 2016-2017 to 2020-2021, the total net rental income on property investments in Australia went from a loss of $3.3 billion to a gain of $3.1 billion (as you can see from the chart below).

For the same period, the proportion of investors negatively gearing their properties dropped from 58% to 47%, as lower interest rates reduced losses.

Negative gearing is also becoming less attractive with the government’s recent changes to tax brackets and marginal tax rates. According to a study conducted by LongView and PEXA, 60% of property investors would be financially better off if they instead put their money into a superannuation fund.

When was it introduced?

Negative gearing has been allowed under tax laws since 1936. It was thought it would encourage investment in housing and increase supply.

However, debate around its impact on housing affordability led the government to partially abolish it in 1985 by not allowing rental property losses to reduce tax on other sources of income.

There was a shortage of housing and rents rose during the two years it was abolished. As a result, in 1987, negative gearing was reinstated and capital gains tax legislation was introduced.

Is it used in other countries?

Canada, Germany, Japan and Norway use negative gearing. In Finland, France and the United States, rental losses can offset future rental income only. In the US, home owners are entitled to claim a tax deduction for mortgage interest on their own home.

The use and benefit of negative gearing depends upon all aspects of a country’s tax system. So although it may be attractive in countries with high marginal tax rates, other taxes such as capital gains tax, land tax and stamp duties may reduce its appeal.

Negative gearing’s impact on housing affordability

Many factors affect the cost of housing, including interest rates, inflation, employment, the overall taxation system and population growth, making housing affordability a complex issue.

In New Zealand, negative gearing is being phased out due to its impact on housing prices.

However, unlike Australia, New Zealand does not have capital gains tax, making negative gearing more popular and more likely to impact housing prices. In addition to phasing out negative gearing, the New Zealand government increased the supply of public housing and relaxed zoning regulations to provide more affordable housing.

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In Australia, however, there are concerns abolishing negative gearing will cause rents to rise, as they did in the 1980s. More innovative approaches to housing affordability are needed to ensure ample supply of property for first home buyers and tenants.

Some consideration could be given to allowing first home buyers to claim a tax deduction for mortgage interest, increasing capital gains tax, limiting the number or type of investment properties held, capping rent increases, or more infrastructure investment from the government for first home buyers and social housing.

One or more of these measures would be a step in the right direction. Negative gearing on its own is not the answer to housing affordability. The whole system needs an overhaul, with a combination of measures needed to adequately address affordability, for now and for future generations.

Taking no action will put home ownership out of reach for even more Australians.