From: kerry@citr.uq.oz.au (Kerry Raymond)
Subject: Negative Gearing
Organization: Prentice Centre, University of Queensland
Date: Tue, 17 Nov 1992 09:20:48 GMT

>The fundamental point is that if I borrow money at say 10% real and use it to
>finance an investment returning say 6% real then I am making a real loss which
>has to be abosrbed by someone somewhere or other.  If the tax system makes it
>possible for an individual to profit in this situation then the tax system is
>absorbing that loss.  It means that overall, our community is incurring a net
>loss even though the individuals doing the negative gearing are making a gain
>for themselves.

Negative gearing and making a gain are not possible simultaneously!
Negative gearing is where the cost of borrowing exceeds the income
produced. When there is a gain (i.e. when the income exceeds the
interest payments), then it is *not* negative gearing.

Suppose I borrow $100K at 10% to obtain a return of 6%. I earn $6K income
and I spend $10K in interest repayments creating a loss of $4K.
This loss of $4K reduces my taxable income by $4K. Assuming I am a high
income earner, then despite the reduction in taxable income by $4K, I will
still be in the highest tax bracket (approx 50%) and the loss of $4K will
result in a tax bill of $2K (50% of $4K) less than it would have been due
to my other income.

So I have spent $10K to earn me $6K income and a $2K tax saving.
Net result = $2K loss to me! Where's the gain to me?

I repeat my point. There is no point in borrowing unless your investment
will in the long term generate more income or capital gain than the cost
of borrowing.

Let us suppose after one year of my investment returning 6%, it strikes
gold and earns me 16% in the second year, i.e. $16K income less $10K
interest repayments. I now have an extra $6K to add to my income and
assuming the highest tax bracket, that translates to an extra tax bill
of $3K.

So (in Year 2) I have spent $10K in interest plus $3K in tax to earn $16K.
Net result = $3K gain to me!

So, is it fair? I say YES because if you look at the lifetime of the
investment (2 years) you see:

Interest payments = $10K + $10K = $20K
Income Earned = $6K + $16K = $22K
Tax Paid = -$2K + $3K = $1K

So in the lifetime of the investment, there has been a profit of $2K
($22K-$20K) on which total tax of $1K is payable which is correct for
a taxpayer at that marginal rate.

>In conclusion, there is no economic justification for negative gearing unless
>the loss making activity must exist for the profit making activity to make its
>profit.

Absolutely!

>For example, negative gearing is one example of the tax deductability of costs
>in a business.  A business can deduct costs such as rent in calculating its
>profit because it would not earn that profit unless it used the property that
>it pays rent on.

>For an opposite example, if a salary earner negatively gears a rental property,
>there is no justification for negatively gearing against his salary because he
>gets his salary regardless of whether he has the rental property or not.

Why is renting out a property not the same as being a shop keeper? Renting
houses is a business! The shop keeper can deduct expenses like rent of the
shop and interest on the loan to pay for the fit-out. The landlord can deduct
expenses like rent of the purchase price (i.e. interest repayments) in exactly
the same way. The rules for rental property deductions are based on the
same principles as any other business. Just as many people who start a
small business have to use other income or savings to tide them through
the initial loss-making years, so do people who buy investment property.
Both are risking their current income or savings because they believe that
in the long term, they will make a profit -- a profit that will then be taxed.

The salary earner's salary *is* the same regardless of whether they have
a rental property but the salary earner's INCOME is not the same. We have
an INCOME tax system and not a SALARY tax system. One salary earner is
investing part of their salary into a business which produces either gains
or losses and pays more or less tax accordingly.

I borrow money for investment because I believe that with that larger
sum of money I can get into investments that will return enough over the
long term to meet the interest payments and leave me with more than if
I had relied on bank interest on my small savings. Provided I remain in 
the same tax bracket throughout the lifetime of an investment, the tax
position should remain neutral (as I illustrated with the simple example
above).

If the tax bracket changes throughout the lifetime of the investment,
then the taxes paid might not be neutral overall; whether you win or
the taxman wins depends on exactly what happens. However, this is true
of any income and deduction situation. It is not unique to borrowing
for investment.

Negative gearing makes it possible to start-up small businesses, whether
those businesses are shops, factories, or renting out property. It's not
evil unless you believe that the only people entitled to try to do better
than bank interest are the people who are already rich.

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