From: yar@cs.su.oz.au (Ray Loyzaga)
Subject: Re: Negative Gearing
Reply-To: yar@cluster.cs.su.oz (Ray Loyzaga)
Organization: Basser Dept of Computer Science, University of Sydney, Australia
Date: Thu, 19 Nov 1992 03:38:26 GMT

In article <1992Nov18.005443.8650@trl.oz.au> c.oneill@trl.oz.au (Chris O'Neill) writes:
>In article <BxusMp.29n@bunyip.cc.uq.oz.au> kerry@citr.uq.oz.au (Kerry Raymond)
>writes:
>>>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!
>
>They are!!

What the guy actually meant to say was that "negative gearing"
is a term used to describe the situation where the costs of funding
a project outweigh the returns, since the most popular example is
property it means that the sum of (mortgage interest, rates, insurance,
utilities, legal and agents fees and various other duties) is more than
the rental income of the property. This property is said to be
negatively geared.  A property is positively geared if the reverse is true.

>Negative gearing does not view the inflationary part of capital gain as taxable
>whereas it does view the inflationary part of interest on borrowings as tax
>deductable.  This is how you make a gain while fobbing the loss on to the tax
>office:

Under the present capital gains tax legislation, nothing views the
infaltionary part of the capital gain, it is the same whether the
asset is negatively geared, positively geared or purchased outright.

>If the real interest rate on borrowings is 10%, the rate of inflation is 8%
>(thus the nominal interest rate is 18%), the real rate of return on the
>investment is 6% and the tax rate is 48.5%, then the negatively gearable loss
>is

What you really mean to say is, you pay an interest rate of 18%,
inflation is 8%, therefor the "real" interest rate is 10%. (obviously
you did your calculations in the late 80's).

>(nominal interest rate) - (rate of return on investment)
>= 18% - 6%
>= 12%
>
>This loss is fully tax deductable, so it reduces tax (on other unrelated
>income) by
>
>12% x tax rate
>= 12% x 48.5%
>= 5.82%
>
>So the net loss to the owner is 12% - 5.82% = 6.18%.  However, when you add the
>capital gain due to inflation, 8%, (which is not taxable), the overall gain to
>the owner is
>
>8% - 6.18% = 1.82%
>
>QED
>So the owner makes a gain and the tax office on behalf of the rest of the
>Australian community makes a loss.

As I said previously, the inflation portion of the capital gain
made by the owner is not taxed whether it is negatively geared
or not. After a while, the asset becomes more positively geared and
the tax office starts getting money. Answer this, how much money
would the tax office make if you didn't invest? How much would it
make in the future?

>>Negative gearing is where the cost of borrowing exceeds the income
>>produced. When there is a gain 

Yup thats a good definition.

>excluding any form of capital gain, inflationary or real,

Yeah, capital gain is not an income is it ...

>>(i.e. when the income exceeds the
>>interest payments), then it is *not* negative gearing.
>>
>>Suppose I borrow $100K at 10% 
>
>I presume you mean 10% nominal.  It is not clear that you understand the
>difference between nominal and real.  The real interest rate is:

Very few people talk about real interest rates, name one bank that
quotes "real interest rates", I note that the real interest rate
was completely irrelevant to your calculations, so why did you mention it?

>real interest rate = nominal interest rate - inflation rate (approximately)
>
>In my example I was talking about 10% real interest rate.

Fine, dwell on the irrelevant.

>>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?

Well, lets get the word "gain" out of this, it seems to be too loaded
a term for this group and beyond the grasp of some. The effect
of the tax deductability of genuine expenses in the pursuit of
income (of which interest payments are one such expense) is to lower
the cost of funds to the investor, i.e  the actual cost of making the
investment is reduced since you are effectively paying the interest
with pre-tax dollars, rather than with post-tax dollars.

>Capital gain.  Remember, we are talking about times of high inflation (during
>the eighties) when the inflationary part of capital gain was enough to cover
>the negatively geared losses.  We are not talking about now when inflation is
>very low.

For a large part of the eighties, there was no capital gains tax, this
came in in late '85. Before that there was a speculative gains tax.
Capital gain is available no matter what the gearing is, the real
benefit to the investor of all this is that they can basically
use capital gains to grow someone elses money, and reduce the cost
of using that money.

>>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.
>
>So you do make a profit.

No, you donate it to the boy scouts, of course you make a profit.

>>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 your example the tax office loses $2K in one year and gains $3K in the
>following year giving it a net gain of
>
>$3K - $2K - interest on $2k
>
>You forgot the interest on $2K term.  This doesn't matter much in your example
>but in a more realistic example where you don't strike gold in the second year
>and where it takes a lot longer for income to exceed interest, the interest on
>the tax office losses is much more significant.  See if you can make a
>realistic example that includes interest on the tax office losses.

Like I said, show me how much money the tax office makes in a zero
investment climate. Or if you disallow interest payments as a deduction,
how much effect will the increased effective cost of funds have on
investment.

>>>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? 
>
>Because there is no way that you need to rent out a property in order to earn
>your salary.  In contrast, a shop keeper must pay his rent to have his
>business.

Maybe the guy is multi-talented and can be a property investor and a
salary earner, or is that a crime? What you are arguing for is that
income losses and expenses can only be claimed in the activity that generates
it, this will also have the effect of reducing activity, as it will
be harder to expand into other business areas because the cost of
funds will be high during the establishment phase of the investment,
the exact time that you need all the cash you can lay your hands on.

>>Renting
>>houses is a business! 
>
>but independent of earning a salary.

who cares.

>
>>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. 
>
>Sure, but why is he entitled to deduct them against some independent source of
>income?

Ok, would you then allow the $5k tax free threshold on each independent
business activity? Or will you treat income in one lump sum? Doesn't
this lead to a bit of a problem???

>>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, 
>
>These losses are part of the capital of the business.  There is no reason why
>money used for capital formation should be taxed any differently from money
>used for any other purpose.
>
But you are arguing that they should be, you are arguing that
the costs of the capital base (interest) should not be deductable,
whereas I would be arguing that the inflation component of earning
interest income should be deducted from the interest to bring it
into line with the capital gains tax rules.

>>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.
>
>After the tax office has lost vast amounts in lost interest.
They haven't lost a thing, thats the law, they are however gouging
the person earning a paltry few percent interest in savings accounts
by not deducting the effets of inflation from the interest earned.
>
>>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 
>
>Well if I use part of my salary to buy shares, I can't claim the cost as a tax
>deduction.  This is an argument about the appropriate circumstances for tax
>deductions.

Of course you can, the "cost" of buying shares are agents fees, which are
deductable.

>
>>into a business which produces either gains
>>or losses and pays more or less tax accordingly.
>
>I know what we've got, but just because we've got something doesn't mean that
>it's right.
>
>>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. 
>
>I know that it may benefit you.  I just wanted to point out how it
>disadvantages everyone else.

So when are you going to start?

>>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).
>
>and if you ignore the lost opportunity cost that the tax office has to bear in
>a realistic example.

Once again you fail to miss the point that encouraging investment is
hardly a case of "opportunity cost".

>
>>Negative gearing makes it possible to start-up small businesses, 
>
>with the tax office as a loss-making shareholder

Lets call it a "subsidy".

>>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.
>
>I don't believe that it's evil to try to do better than bank interest but that
>doesn't mean that I think negative gearing is not evil.

Funny, I think that in many circumstances, capital gains tax is evil.
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