When borrowing is used to fund a large proportion of some investments, annual income tax deductions associated with the investments, including deductions for interest repayments on the debt funding, may be greater than annual assessable receipts over a number of years. This situation - commonly called 'negative gearing' - applies to a wide variety of investments, with rental property investments often singled out for particular scrutiny.
In Australia, for example, it is a commonly-held view that there are 'negative gearing' rules in the income tax law. These rules supposedly allow taxpayers to apply annual excess of deductions over receipts from rental property investments to their other assessable income (like regular wage income) and so reduce their overall taxable income and tax payable. This so-called concessional treatment is often blamed for contributing to housing price spirals. Removal of 'negative gearing' is invariably included in lists of potential tax revenue-raising measures.
There are no such negative gearing rules in Australia's income tax laws.
Despite the absence of general negative gearing rules for commercial investments, is negative gearing itself a problem that needs to be addressed? More generally, are there problems with the tax treatment in Australia of assets like rental properties - problems that investors may be able to exploit to further advantage by gearing up with debt funding?
NEUTRAL TREATMENT OF ANNUAL INVESTMENT LOSSESThe 'benchmark' income tax base that offers taxation with limited effects on investment decisions includes the annual change in value of assets and liabilities along with the usual recurrent receipts and costs. Figure 2 illustrates the neutrality properties of the benchmark tax base. Pre-tax returns of 10% across alternative investments are reduced to 5.3% for taxpayers on a 47% tax rate and to 7% for taxpayers on a 30% tax rate. Investment decisions after taxation according to this benchmark should be in line with what decisions would have been in the absence of tax.
This neutrality outcome requires a symmetrical tax treatment of annual positive and negative income under the benchmark - consistent with commercial reality where both future profit and loss expectations determine investment decisions. If positive benchmark income arises in a year (benchmark profits made), tax is paid at the investor's tax rate. If negative benchmark income occurs in a year (benchmark losses made), the investor should realise tax savings for that year equal to the loss times the investor's tax rate - that is, obtain full loss offset.
Therefore, contrary to popular belief, the annual cost to revenue of allowing losses from a particular commercial investment of a taxpayer (like a rental property investment) to be offset against the taxpayer's other assessable income should not be viewed a tax concession or 'tax expenditure' (imposing budgetary costs just like direct budget expenditures) and a potential candidate for revenue raising. In the absence of full loss offset provided by governments, negative gearing is, in fact, an important contributor to sound investment decision-making.
If negative gearing represents sound tax design, are there any design problems with the taxation of assets like rental properties and, if so, how do these interact with borrowing to fund investment in these assets? Numerical examples are used in the following section in an attempt to identify and address underlying problems in the tax treatment of investments like rental property investments.
NEGATIVE GEARING ANALYSISFigure 10 looks at three assets over 5 years: a depreciating asset declining in value at 15% a year; an appreciating asset increasing in value at 10% a year; and a regular bank account. Each asset offers a return of 10% before tax. Under the benchmark income tax treatment, for an investor on a 47% tax rate all of these assets offer a 5.3% return. Risk aside, the investor would view investment across these alternative assets similarly after tax as before.
If, however, the depreciating asset attracted accelerated depreciation allowances of 30% (reducing balance) - rather than the 15% required under the benchmark to match actual decline in value - its after tax return would be 6.0%. Similarly, if the appreciating asset were taxed on only half of its capital gain when it was sold at the end of 5 years - rather than taxed on the full accrued gain in each of the 5 years as per the benchmark - its after tax return would be 8.0%. Again risk aside, there would be a pull in investor interest towards the depreciating and particularly the appreciating asset and away from the bank account.
The depreciating asset (costing 400) and the appreciating asset (costing 1000) could be combined in an stylised investment project - the project could be construed as a rental property comprising a depreciating building on appreciating land, even though the 15% rate of value decline for the depreciating asset is high for rental buildings. The investor has plenty of other income against which to offset annual losses from the investment and so achieve full loss offset. Absent second-round price effects and any borrowing, the 10% pre-tax return of the combined assets becomes 7.6% after tax.
The investor decides to use borrowing to help fund the investment. The investor borrows 1330, or 95% of initial cost, under a simple interest loan at the 10% pre-tax bank interest rate. The post-tax return of the investment becomes 41.1%. With no gearing, the project offers the investor 7.6% post-tax return (compared to 5.3% from the financial market) because of concessional tax treatment (accelerated depreciation and not taxing annual accrued gains). But, by borrowing, the investor can 'gear up' the effect of the concessional treatment, with after-tax returns seemingly able to be increased as much as desired by simply increasing the level of gearing.
The 10% pre-tax return of the project has been turned into 41.1% after tax by gearing up the depreciation and CGT concessions - with apparently even higher returns on offer with higher gearing. Such attractive returns would, however, rapidly draw investors into this type of project. Associated asset prices would be expected to rise considerably. (Asset price-linked CGT exclusions - like half the realised gain being excluded - might also be expected to engender asset price volatility.)
On the assumption that asset prices increase until the after-tax return of assets is reduced to the going 5.3% available from the financial market, the price of land increases from 1000 to 1585 and the price of the depreciating asset increases from 400 to 439. The cash flows of the overall investment project (combining the depreciating asset, the appreciating asset and the debt liability) are shown in Figure 11. With the amount of debt unchanged at 1330 despite the increased asset prices, the gearing drops to 66% in the first year of the project.
With full loss offset applying, the after tax return of the overall project is also 5.3%. The degree of concessional treatment is reflected in the fact that the project only has to return 2.2% before tax (and after the asset price rises) to achieve the 5.3% after tax. Those unable to get in early with investments into this type of investment project and beat the asset price rises end up earning the same return available from financial markets despite the tax concessions available. Over its 5 years, the project causes a 101 net drain in income tax revenue - though Figure 11 (as with the other figures below) does not include the tax revenue collected on the annual 133 of interest received on the project's 1330 of debt.
Debt funding certainly can superficially gear up concessional tax treatment to produce initially inflated after-tax returns. Those inflated returns are, however, quickly dissipated by asset price rises associated with the diversion of investment into projects attracting the concessional treatment. Nevertheless, only having to earn 2.2% before tax to be worthwhile after tax is still an issue. Why not respond by forcing the project's annual losses to be quarantined to future income from the same project? Figure 12 shows the effect of imposing loss quarantining measures on the project. In the short term before any reductions in demand caused by quarantining dampen the price effects, the after-tax return becomes 2.2% - the same as the return before tax. The project provides no tax revenue to the taxing authorities and no tax savings to the investor. The accumulated annual losses carried forward under the quarantining measure are greater than the amount of assessable income produced by the project in its final year.
The Figure 12 result may seem a reasonable response to the gearing up of concessional tax treatment. But there are major shortcomings associated with such loss quarantining:
Figure 13 shows the overall effect of removing accelerated depreciation from the depreciating asset ('benchmark' treatment) and taxing the appreciating asset's accrued gains annually ('benchmark' treatment). As before, 95% of debt funding is used.
Tax revenue is collected from the project (as opposed to tax revenue losses with tax consessions plus no binding quarantining and no tax revenue with tax concessions plus binding quarantining). There is no artificial diversion of investment funds into this type of investment. The investment offers a 5.3% after-tax return for investors on a 47% tax rate, the same as that available to those investors from financial markets. There are no asset price effects - the price of land is back to 1000 and that of the depreciating asset back to 400.
Version 1.1 © Copyright Wayne Mayo 2009