Negative Gearing Concept & Implications

Question: Describe about the Negative Gearing for Concept Implications. Answer: Abstract The aim of the given report is to present an overview of the concept of negative gearing in regards to assets particularly shares and property. Negative gearing refers to a situation where the underlying income drawn from the asset is insufficient to cover the interest expenses on the amount borrowed for purchasing the asset. This is widespread amongst investors due to the underlying tax savings that could be reaped as the loss on these assets could be offset against the taxable income and hence lower tax liability. However, if investors tend to purchase assets driven by tax saving only, negative gearing may lead to asset bubbles and lead to systematic risk to stability in the financial system. As a result, it is imperative that regulation of the tax incentives in negative gearing must be done so as to ensure that genuine buyers are not discouraged and systemic stability is maintained. Introduction Property and Shares have emerged as a valuable asset which provides an alternative to various investors who have surplus money. With regards to buying property specially houses or built up office spaces, it is usually the case that funds available may not be sufficient and thus a significant amount of funds may be borrowed which are repaid in a systematic manner. The investors tend to put the property on rent and tend to derive regular rent payments besides long term capital appreciation. Based on the relative comparison of the rent income with the respective costs borne by the property owner, a property may be termed as positive geared or negatively geared (Hazel, 2015). The aim of this report is to introduce the concept of negative gearing with reference to the various implications (positive and negative) that it has for the potential investors who pursue this method. In this regard, it is imperative to consider the underlying volatility that is observed in the property prices in t he recent times especially in the aftermath of the global financial crisis. It is apparent from this research that negative gearing is a double edged sword and hence caution must be exhibited while investing in such assets especially in a risky and volatile environment. Concept of Negative Gearing Negative gearing refers to a situation where the income derived from the property in the form of rent is lower than the total costs associated with property ownership on behalf of the owner. Since the expenses tend to exceed the income, hence for such properties, the taxpayer would realise a loss and hence such properties are known as negatively geared properties. In contrast, positive gearing implies the situation where the rent revenue would exceed the ownership costs and hence the owner would report a positive taxable income from the property (Wyatt, McDonald Nandha, 2005). The various expenses that are included in the list of ownership costs are interest expenses on property loans, legal fees, land tax, depreciation, insurance, repair and maintenance, council taxes, property management fees and charges related to cleaning, gardening and lawn mowing. Similar concept may be extended to shares as well whereby negative gearing may exist in situations where the dividend income does n ot cover the interest cost on borrowings used to finance buying of portfolio (Hanegbi, 2002). Example: Consider a property which has been purchased for a price of $ 400,000. Further, it is assumed that the given property is rented with expected proceeds of $ 500 per week. Additionally, the various ownership costs which include all the above costs amount to $ 600 per week on the average. Hence, it is apparent that expected annual taxable income from the property would be (500-600)*52 = -$ 5,200. Due to the expected property costs exceeding the revenue derived, thus resulting in a negative taxable income from the property, this property is an example of negatively geared property. Implications of Negative Gearing Based on the underlying concept of negative gearing, it is apparent that it refers to a situation where the investor makes loss on the asset. This gives rise to a pertinent question as to why the investor would prefer to do so. The various advantages of negative gearing are highlighted below. Tax saving The major advantage associated with assets that are negatively geared is the fact that the losses made on such assets could be utilised for lowering the taxable income of the investors. As a result, the investors with high amount of taxable income from their business or employment tend to invest in negatively gearing assets so as to lower their underlying tax liability. In Australia, the incidence of negative gearing is widespread in case of rented properties as it allows the owners to offset the losses derived from their rented properties against the personal taxable income (Hazel, 2015). Capital growth strategy Since the continuous ownership of asset presents an incentive to the owner in the form of tax saving, hence negative gearing promotes long term ownership of the asset which invariably leads to capital appreciation in the asset value and atleast ensures that the final asset price is atleast equal to the acquisition price if not more. However, in most cases, this leads to wealth creation for the investors (Sedgwick, 2008). Despite the positive associated with negative gearing, it is imperative to consider certain disadvantages associated with negative gearing which the investor must keep in mind. These are highlighted below. Higher Risk The amount of risk associated with this mechanism is comparatively greater especially in the current volatile times as the underlying asset price may plummet due to market shock as was observed in the case of global financial crisis. Due to higher volatility in the underlying asset market, the investor may suffer nominal capital erosion. This loss of capital may significantly outweigh the tax benefits owing to negative gearing. As a result, the investors should be cautious with regards to investing in only quality assets as if investment is done only with purpose of saving tax, then the strategy could backfire (Soos, 2012). Systematic Risk It is quite possible that the asset price of share or property may plummet to such an extent that there is no incentive for the asset holder to continue making the interest and principal repayment for the borrowed amount for financing the asset purchase. In such cases, it is quite possible that the asset owner would default on the loan repayment and the bank would have no option but to liquidate the underlying asset whose fair market value may be lesser than the loan extended. Such incidents if replicated on a large scale could potentially trigger a financial crisis and threaten the underlying stability of banking system as was evident during financial crisis (Yates, 2008). Overpriced asset If the decision of the investors to purchase a given asset is strongly driven by the intention to real tax savings, then there is a distortion in the market whereby investors who have incentive in the form of tax savings would tend to buy the assets whereas genuine buyers of property and shares may be sidelined or would have to purchase the asset at a higher price (Wyatt, McDonald Nandha, 2008). Also, negative gearing if widespread may lead to asset bubbles and hence requires regulation (Sedgwick, 2008). Conclusion On the basis of the above discussion, it is fair to conclude that negative gearing implies an underlying asset to have negative taxable income from the asset. This is usually done by investors in order to save on taxes as these losses on assets can be offset against the taxable income. However, in lieu of the underlying asset volatility, there are potential risks of indulging in negative gearing. It may lead to formation of an asset bubble besides leading to higher defaults on loan which may trigger a crisis and cause instability in the financial system. As a result of the implied risks, it is imperative that prudent measures should be undertaken to limit the tax incentives associated with negative gearing so as to encourage genuine buyers and ensure that assets are fairly priced. References Hazel, B 2015, Discourses around negative gearing of investment properties in Australia, Housing Studies, DOI: 10.1080/02673037.2015.1080820 Hanegbi, R 2002, Negative Gearing: Future Directions, Deakin Law Review, Vol. 7, No. 2, pp. 349-357 Minas, J Lim, Y 2013, Taxing capital gains views from Australia, Canada and the United States, eJournal of Tax Research, Vol. 11, No.2, pp. 191-215 Sedgwick, S. 2008, Policy Forums: Housing Affordability: what are the policy issues?, The Australian Economic Review, Vol. 41, No. 2, pp. 187-194 Soos, P 2012, Its time to abolish negativegearing, The Conversation, Available online from https://theconversation.com/its-time-to-abolish-negative-gearing-9879 (Accessed on October 11, 2016) Wyatt, K, McDonald, J Nandha, M 2005, Negative Gearing and Housing Affordability, Journal of Australian Taxation, Vol. 8, No.1, pp. 150-159 Yates, J 2008, Policy Forums: Housing Affordability: what are the policy issues? Is there a housing crises? 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