Borrowing for investment is back in the news. Shadow Treasurer Bowen’s office has confirmed that Labor’s proposed changes to negative gearing will apply to all assets, including shares and managed funds – with the single exception of new residential property.
It’s a highly controversial policy. Just this week Aussie Home Loans founder John Symond claimed that Labor’s negative gearing “hand grenade” could tip Australia into recession.
From a purely philosophical point of view, I think the proposed changes are bad policy. Restricting the ability to deduct losses on investment borrowing to a single type of investment – new residential property – will add unnecessary complications to an already complicated tax system and give us more “grandfathering” to worry about. And it will undoubtedly lure some unsophisticated investors into financial strife.
Today let’s stick to the basics and think about borrowing for investment in general, and negative gearing in particular. For starters, let’s make one thing perfectly clear: negative gearing is not much of a tax-saver.
Think about a person earning between $90,000 and $180,000 a year. If they borrowed $500,000 at 5% to buy a residential property for $550,000 with a net yield of 4%, the cash shortfall would be $3000 a year (ignoring depreciation allowances, which depend on the property purchased and are clawed back on sale anyway). The tax refund would be just $1170 a year, including the Medicare levy. You would need to be a serious odds-on punter to borrow $500,000 just to save $1170 in tax.
So, the purpose of borrowing for investment is not to save tax, but to put the power of leverage to work for you. But leverage is a two-way street: it magnifies whatever is happening, positive or negative.
If the above property increases in value by 10%, the investor has made a profit, at least on paper, of $55,000 – more than doubling their original stake of $50,000. Conversely, if the property falls by 10%, the investor has lost their entire equity and more.
Obviously, the critical issue in choosing residential property for investment is not any tax breaks you may have at the outset. The key is to find a property that is under-priced and has the potential to increase in value over the long haul. For this, the vital thing is location, and the likelihood of increased demand for properties in that area. Successful property investors buy well, and add value by their own efforts and/or by growth in the area.
This is why astute real estate buyers look for the worst house in the best street. The best street will have location, and the worst house should be capable of having value added to it by refurbishment, and in some cases even by rezoning. They also look for a vendor who is highly motivated for a quick sale due to personal factors such as a job transfer, relationship breakup or financial strife. As one seasoned investor told me: “the day you make the money is the day you sign the contract”.
It would be almost impossible to find these factors in a brand-new property, which is why I believe Labor’s proposed changes to negative gearing will entice inexperienced “investors” into new properties to which they can’t add value. It will be a bonanza for property spruikers, who are still unregulated.
The worst feature of all this talk about negative gearing is that it moves the focus of the investor from the potential of the asset to be purchased, to the investment strategy which will give the greatest tax breaks. Never forget the principle that any investment must stand on its merits – tax benefits, if any, are simply the cream on the cake.
- Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal firstname.lastname@example.org