Taxation Law And Practice

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Taxation Law And Practice

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Taxation Law And Practice

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Question:

Describe about the “Negative Gearing and its Effects”.

Answer:

Introduction
Australian investors are making the most of the real estate sector by reaping rich profits from the combination of negative gearing and discounts on capital gains. The housing sector is coming under pressure because of the savings being made by taxpayers on capital gains tax (CGT) because of the loopholes left by negative gearing. The investors are getting encouraged and are taking full advantage of the benefits being rolled out by the Australian taxation Office (ATO). Especially making use of the benefits are the high income individuals whose tax savings are increasing, (Barkoczy, 2015). A survey conducted by The Australia Institute has revealed that these factors are putting the government to a loss of $7 billion annually. The survey also reveals the fact that taxpayers falling in the middle income bracket, who are contributing the highest percentage of tax amount to the ATO, is not getting anything from these benefits. In fact, 67% of the benefit goes to the top 20% of the taxpayers and only about 4% of households in the low income earning are being benefited by this scheme, (Barkoczy et al, 2010).
When the benefits of negative gearing are combined with the discounts given on capital gains to taxpayers, a vast majority of investors in Australia are being encouraged to invest in the residential property sector, thus pushing-up the prices in this sector. This is also lowering the percentage of the genuine home buyers who want a home for their own use, (Nethercott, Richardson & Devos, 2010). Even the financial institutions are encouraging investment in housing sector with the result that investment is getting concentrated in the limited investment property sector and this is an alarming situation for the Australian economy. Investors are becoming rich at the cost of other people’s money by collecting tax benefits and are also booking their losses against the rental incomes they are earning without paying any tax to the government, (Ault, Arnold & Gest, 2010).
The Interest Factor in Negative Gearing
In the opinion of the taxation experts, and I quote “Negative Gearing is a benefit derived by a taxpayer from an investment property in the form of a loss”. Unquote. The biggest factor playing a prominent role in this happens to be the interest which the borrower pays on the loan taken from the financial institutions for buying the investment property. The property may or may not earn large amount of rental income, but the borrower gets the advantage of claiming the interest amount from any other assessable income which it declares during the income year in which the interest is being paid, (CCH, 2015). Thus, even if the investment property does not provide any income, it does give an avenue for reducing the tax liability to the borrower[1]. Moreover, if the rental income is low and the expenses incurred on maintaining the investment property are high, the taxpayer can still claim deduction of the excessive expenses from other assessable incomes earned. In other words, the loss being incurred by the investor from the investment property is getting compensated by the tax saving being made from the other assessable incomes and the deductible expenses which would also include the interest payment made on loan taken for buying the investment property, (Lindahl, 2008).
Taxation experts consider such investments as unusual investments because the government is compensating the loss being generated by the investor. IN the normal course of running a business, the owner tries to make the most from their investments and take utmost care and work with the intention to make profit, (Lindahl, 2008). But in the case of negative geared investment properties, all the investments in the residential investment properties, are made with the sole intention of creating a loss so that the advantage of negative gearing can be taken for availing the permissible deductions. Another factor which favours the investors is that although investors are incurring losses in cash terms on the investment property, the property itself is actually getting increased in value, (Bakker & Kloosterhof (ed.). 2010).
Capital Gains and Negative Gearing
Let this paper take the case of capital gains in situation where an investor sells the investment property. At the time of sale, under normal conditions, the property is worth more than its price when it was purchased, (Bakker & Kloosterhof (ed.). 2010). Since the value of the property has increased over the years, the investor is making a capital gain and this will be subjected to capital gains tax (CGT) according to the Australian taxation law. The taxpayer pays CGT on the net value of the capital gain, which is arrived at after deducting all the expenses incurred on maintenance and sale of the property, which the taxpayer can claim from sale amount of the asset, (Barkoczy et al, 2010). The Australian Taxation Office (ATO) introduced a 50% discount in 1999, which was allowable to taxpayers on the net Capital Gain made by them on the sale of a capital asset, provided the asset has been held by the owner for a minimum of 12 months and the net gain is then subjected to the CGT, (Barkoczy et al, 2010). The purpose was to allow more investment in housing sector by luring the investors with the discount, as the taxpayer was to pay tax on only half of the capital gain amount which was earned from the sale of the investment property. The taxpayer is not only allowed deductions on the ongoing revenue losses (expenses incurred) during the period of ownership of the investment property, it is also getting the advantage of paying income tax on a fraction of the gain which it has made from the sale of the investment property, under the legally admissible negative gearing. This additional discount of 50% allowed on the capital gain amount in fact permits the taxpayer to collect the full amount of the investment made by it, at the expense of the government, (Nethercott, Richardson & Devos, 2010).

Effects of Negative Gearing and CGT on Housing
In Australia, the ATO has been promoting a generous tax treatment to the investments being made in rental property sector. Unlike most of the advanced countries of the world, taxation in Australia does not follow a set limit for allowing the deductible expenses which a taxpayer can claim against those expenses which are related to investment properties, (McCouat, 2012). In the case of ‘negatively geared properties’, investment related expenses, including agent fees, stamp duty charges and the interest paid on the loan amount often exceed the rental income earned. The problem is not addressed logically as the investors are not making any losses because the value of the property increases every year, (McCouat, 2012). The other advantage available to the investor is that ‘capital gains’ do not get included in the taxpayer’s taxable income till the property is sold. Hence negative gearing has become the combination of the capital gains, which are taxed at half the marginal tax rate after the sale of the property and the advantage provided to the taxpayer for claiming unlimited deductions on account of the incurred expenses. This taxation system is encouraging taxpayers to borrow more for the purpose of speculating in investment properties, (McCouat, 2012).
Australia reports the second highest housing price to income ratio among the member OECD countries. This happens not because the houses in Australia are becoming more costly for the genuine Australian buyers, it also happens because the international property trends are showing that Australia has high level of house pricing in comparison to the other member OECD countries. The size of the losses being claimed by taxpayers from the investment properties has grown since 2000 in Australia. According to the available data, the net rental income in 2000 was $219 million and in the last one decade, this has turned into net rental loss, which in 2012 was $7.9 billion, (Lomas, 2011).
Not only the tax revenues are getting reduced because of this combination of Negative Gearing and CGT Discount, it is also contributing to the problem of housing affordability in Australia. Another effect felt is on the increasing housing prices, but this is purely speculative because this is there because of the favourable tax treatment given to the investment properties and this is attracting more investors in buying the rental properties and the additional investors are able to outbid the genuine buyers, (Renton, 2012).
Negative Gearing and Rental Income
The growing rental loss trend is showing that Australian rental property investors are not concerned with the rental yield gained from the investments but are focussing on the capital gains only and these are being offered to them with the combo-pack of incentives of the negative gearing and the 50% CGT discount. The argument out forward by investors for to the government for not removing negative gearing is that if this is done it will increase the rentals and this will largely affect those majority of low income earners, who are the major users as tenants of the investment properties, (Renton, 2012). And the logic given by the investors is that it is because of the negative gearing factor that the investors are getting encouraged in building more houses for these low income earners. This, they state, is actually responsible in making the rental prices low and more investments has been out in to increase the supply of the rental properties, (Ault, Arnold & Gest, 2010).
In case this argument is found to be correct, then the major portion of houses which are purchased for availing negative gearing should have been in the new housing sector. On the contrary, a survey of ABS shows that only 6% of investments have been made in the new housing stock and a large segment of investors are buying the existing housing stock, (Ault, Arnold & Gest, 2010). This also becomes evident from the data which shows that the percentage of investment loans in the new house segment has declined. In 1992, the loans for new houses were just 18% of the total property loans and presently the figure is only 6%. This shows that more than 94% of loans in the investment housing property sector are for existing housing stock and only a small portion of the investments are being put for producing new housing stock into the market, (Ault, Arnold & Gest, 2010).

A Few Facts about Negative Gearing
Fact – 1
The reason for increase in rents in bygone times was because of the higher interest rate, combined with boom in the share market. This resulted in diversion of investments from the rental property market although this was limited only to Sydney and Perth, in fact, lending to rental property investors rose by 42% across Australia, (CCH, 2015).
Fact – 2
Negative gearing has been the fuel during each housing boom as it has been encouraging speculations in the property sector. In recent times, the impact has been seen as growing because the investors have a more easy access to credit. Moreover, the provision of 50% discount on capital gains, which was introduced in 1999 has also helped in making negative gearing a more attractive proposition for investors, (Barkoczy, 2015).
Fact – 3
It is wrong to suggest that benefits of negative gearing are majorly enjoyed by those investors who belong to the middle income earning segment in the society. This has been portrayed wrongly as the Taxation Statistics to prove this fact are taken after taking into account the deductions claimed by taxpayers for rental property investment, which are already reduced by negative gearing strategies, (Barkoczy, 2015).
Fact – 4
Most households which appear in the ‘middle income earning segment’ are actually high income earning taxpayers but are included in the said segment before the deductions are subtracted from their incomes. Actually, more than 50% of the individual taxpayers involved in the negatively geared rental housing investments are in the top 10% bracket of personal taxpayers whose earnings are above $100,000 and about 30% who earned above $500,000, (Barkoczy, 2015).
Negative Gearing and CGT Discount – What Can be Changed?
When there is a proposal to carry out some changes in negative gearing and CGT discount, it is very essential for those in the authority to consider how to retain the positive aspects of the current policy in the revised policy and also to consider a smooth transitional arrangements, (Renton, 2012). Negative gearing should be used for creating additional new houses to be built but as the discussion above shows, this can happen only in small numbers. Any proposal for reforming the policy should also take into account that negative gearing is only for the new houses and that to for the limited period. Such a change will not impact the investors who are planning of buying new housing stock only to avail negative gearing. Such changes in the policy framework will only make a positive impact on the building of new houses, (Lomas, 2011).
Taxpayers who are wanting to invest money in residential property sector are finding that buying a house from the new house stock gives a bigger tax advantage as compared to buying from an existing housing stock. This increases the low investment rate being experienced presently in the new house stocks for rental investment properties. When a change in policies is made and which will affect the residential investment properties, it is important for the authorities not to frame such policies which may develop a sudden change in the property sector. If negative gearing can be restricted currently only for new investment property stocks, there is always the possibility that large number of unsold investment properties will be left unsold in the real estate sector and this will cause an instability in the prices of the houses, (Lomas, 2011).
Conclusion
Currently, the housing policy issue has become a diverse economic agenda for the Australian economy. Taxation experts speculate if it will be bad or good for the country’s economy if housing prices start increasing in Australia. The experts are of the view that answers to these speculative questions will be different for every individual. This is so because different people will offer different points of view and their views will depend chiefly on the type of house they own now or wish to buy one in the near future. Such situations may be good only for the investor who either has an investment property or who is looking for opportunities to downsize their present house or for those who are planning to move from a highly expensive area to a less expensive area. Such speculations, in their true meaning, are quite adverse for those taxpayers who are planning to buy their first home or for those who wish to buy a bigger house because their family is growing.

References
Ault, H. J., Arnold, B. J. and Gest, G. (2010) Comparative income taxation: a structural analysis. (3rd ed.) Amsterdam: Kluwer Law International.
Bakker, A. and Kloosterhof, S. (ed.). (2010) Tax risk management. Amsterdam: IBFD.
Barkoczy, S., Rider, C., Baring, J. and Bellamy, N. (2010) Australian Tax Casebook. (10th ed.) Sydney, NSW: CCH Australia Limited.
Barkoczy, S. (2015) Australian Tax Case book, (12th ed.) North Ryde, NSW: CCH Australia Limited.
CCH. (2015) Australian Master Tax Guide. Sydney, NSW: CCH Australia Limited.
Lindahl, D. (2008) How Small Investors Can Get Started and Make It Big. Hoboken, NJ: John Wiley & Sons.
Lomas, M. (2011) How to Invest in Managed Funds. Hoboken, NJ: John Wiley & Sons.
McCouat, P. (2012) Australian Master GST Guide. (13th ed.). Sydney, NSW: CCH Australia Limited.
Nethercott, L., Richardson, G. A. and Devos, K. (2010) Australian Taxation Study Manual: Questions and Suggested Solutions. Sydney, NSW: CCH Australia Limited.
Renton, N. E. (2012) Family Trusts: A Plain English Guide for Australian Families of Average Means. (4th ed.) Milton, QLD: John Wiley & Sons.

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