By now I’m sure everyone is aware that it is only a few weeks until we have the 2019 federal election. I don’t doubt between now and then you’re going to hear a whole heap more about it via the media. I will try and minimize the commentary on the politics in this post, but it is looking likely that labor will become the sworn in government. How likely? I think the easiest way to quantify this is looking at what the bookkeepers are paying; Labor paying $1.25 for the win and the Coalition/Liberal at $3.85 (two weeks ago this was $1.18 vs. $4.75).
So with this being a statistically likely outcome, I thought it’d be useful to help people understand what two of the key policies that Labor has introduced in relation to property:
- The elimination of negative gearing for investors
- The reduction in the capital gains tax discount for investors
Just a reminder up front, the below is not financial advice so please seek specific professional advice for your situation.
Firstly what is negative gearing? It is the common term referred to when investors use interest (and other costs) to offset the income that an investment earns. This is commonly recognized as being advantageous from a tax perspective, as an investor may be offsetting their PAYG income against the cashflow loss of the investment, while that asset appreciates over time.
Let’s look at a working example. An investor buys a property for $600K, with a 20% deposit and a loan size of $480k (80% LVR).
The property returns $400pw rent (roughly 3.5% return) and the Interest Only loan (5 year term) interest rate is 4.6%. In real simple terms ignoring all other elements, rental income over 12 months is $20,080 and interest cost is $22,800. The investor will need to make that shortfall up with a cashflow contribution ($1280 per year), but under a negative gearing arrangement that loss can be taken off their taxable income.
Why would an investor buy something that loses them money? They wouldn’t, the other part of the equation is capital growth. Assuming the property grows only 10% over that 5 year period of time from $500k to $550k then the investor has made $50K capital growth. Throughout this time they’ve only had to manage a total of a $6,400 cashflow loss which they’ve negatively geared against their PAYG income, so depending on their marginal tax rate they’re going to be well ahead.
Please note this example ignores a heap of variables – property management fees, property growth cycle (sometimes growth over 5 year is significantly more, sometimes a contraction), depreciation benefits, and other costs but for the purposes of the concept hopefully it makes sense.
Summary of negative gearing proposal under labor:
- Negative gearing benefits will be removed for any established property purchases.
- Any investors who hold property before the effective date (1/1/20) will still have negative gearing apply to the properties in their portfolio.
- Going forward from that date, negative gearing will only be effective for brand new property.
This then makes investing in established property way less attractive for investors. It is also a balance, as investing in brand new properties generally do not offer the growth opportunities of an existing property. You’re often paying the developer a margin on the cost to build, and there is no renovation opportunity like there is with established property.
Capital Gains Tax (CGT)
So back to the capital gain from our example where the investor had made $50K (gross) in capital gain. If they were to sell that property they would be liable for the profit they’ve made from the investment.
Under the current rules, CGT is payable on the profit but you receive a 50% discount on this if you’ve held the asset for over 12 months. In this case it would be $50K x 50% = $25K added to the income of the investor in the year they sell the asset.
Summary of CGT proposal under labor:
- Reduction in CGT discount from 50% to 25%.
- Any investors who hold property before the effective date (1/1/20) will still have the 50% CGT discount applicable.
- Please note CGT is not applicable for owner occupied property (unchanged).
So, taking the same example if this was bought after the cutoff date the investor would be liable for $50K x 25% = $37,500 CGT liability which is a difference of $12,500.
That may not seem significant on smaller numbers, however I can contrast an example from my own portfolio and the difference of if it was bought BEFORE vs. AFTER the proposed CGT reform.
- Purchase in 2010: $640K
- Market Value Today: $1.4M
- Profit: $760K
- Current Scheme: $380k CGT liability
- Labor Scheme: $570k CGT liability
That would mean a difference of $190,000 which is a significant difference. Combine this with the loss of negative gearing benefit, and property investment becomes a less attractive asset class.
I’ve ignored a heap of variables in these calculations (like stamp duty, buying costs, agent selling costs etc) just to keep it simple for the purposes of the concept. Hopefully it makes sense.
These policies have the potential to be quite detrimental to the real estate market and encouraging investor activity. There are a host of different ways it might play out in the market and the reality is that there are going to be those who can better navigate the changes than other and will benefit and profit, while others will lose out. For instance, buying an investment property before end of this calendar year may make a tangible difference in your retirement position by taking advantage of the window we have to buy under the current scheme.
Again, this isn’t meant to be a discussion on political alignment, but to be clear I don’t believe in these two policies, added to the already public support that Labor has given around negatively impacting the mortgage broking industry and crippling competition so in the interests of full disclosure of my bias I won’t be voting for them.
Hope this helps everyone – of course we are lucky enough to be able to form our own opinions and vote accordingly. Enjoy the sausage sizzles nationwide!