Housing affordability is a goal of governments and opposition parties in Australia. A topic of discussion in the media is whether negative gearing combined with the capital gains tax discount (‘tax concessions’) increases speculative activity in the housing market – to the disadvantage of the first home buyer.
Identify and evaluate key arguments both for and against retaining these tax concessions if housing affordability is to be achieved.
Jai is 50 years old, currently employed and planning to retire when he is 70. As part of his plans for retirement Jai recently sold the large home he has lived in for many years – planning to purchase a smaller home to live in and also an investment property.
After paying expenses associated with the sale and repaying his home loan Jai was left with $200,000 cash. Jai has placed an offer of $200,000 with a real estate agent to purchase a home which will be Jai’s principal place of residence. Jai has also placed an offer of $150,000 to purchase an investment property to be used for rental income.
Jai does not have enough funds to complete the sales on both properties, but his bank manager has approved a loan for the shortfall of $150,000 at an interest rate of 5% per annum.
In order to prepare loan documentation, the bank manager needs to know whether Jai will:
a) use the $200,000 cash to pay for his new home and use the borrowed funds of $150,000 to purchase the investment property;
b) use $150,000 of the cash to pay for the investment property and then pay for his new home with the remaining $50,000 cash and the borrowed funds of $150,000; or
c) pay for his new home by using $100,000 of the cash and $100,000 of the borrowed funds; and pay for the investment property by using the remaining $100,000 cash and the balance of the borrowed funds ($50,000).
Assume Jai’s goal is to take advantage of negative gearing opportunities and receive the most favourable tax treatment. Advise Jai which of the three options – a), b) or c) – would best achieve this goal. Give reasons for your answer.
This assignment, carries discussion and recommendation about investment aspect under income tax law. The cases in this assignment carries focus, planning and executing the strategy of investment so that the maximum advantages of deductions, concessions can be achieved within the purview of provisions under Income Tax Assessment Act 1997 laid by Australian Taxation Office against the tax liability payable. The assignment also provides the explanation of tax concessions and other relevant aspect of capital gain along with the relevant rulings and cases. The presentation also considers the important aspect of investment i.e. negative gearing opportunity, its relevance and importance for long- term investors as well as first time homebuyers.
In the present market structure and tax reforms in Australia, housing affordability has been a matter of concern for individuals or middle class families because the possession rates in recent years have coiled downwards from around 60% to 48%. According to surveys conducted in various countries which stands at par to that of Australia, it was analyzed that household debt is highest in Australia which is equal to 130 % (approx.) of GDP while that in other areas it is around 78% and such huge growth in the debt percentage is due to greater popularity in real estate investment which was promoted by the two concessions enforced by Australian Taxation Office i.e. negative gearing and capital gains tax discount (Götze, Northcott & Schuster, 2015). Whereas some other sources presents that these tax assistance are not the main reasons behind lack of housing affordability, but it is because of lack of supply. In general economic terms, we all know the inverse relationship between demand and supply, i.e. if demand increases and supply constraint is there then the prices of such products rises. It is also monitored from few reliable sources that the maximum percentage of inviduals availing negative gearing tax concession for the measurement of their tax liability have modest earning of income therefore, it cannot be said that the real estate marketability has sweeped down for new investors because of the tax concessions introduced by the Australian Taxation Office.
Negative gearing is a process under which an investor acquires an income generating investment, (mainly property) whose cost of acquisition and cost of maintenance is generally higher than the gross income expected to be generated. Under this strategy investor incurs short to medium term tax losses which in turn helps a tax payer to leverage his potential incomes or gains (Dore, 2015). Negative gearing is considered to be a tax concession because the loss generated out of this strategy is used to reduce the other taxable income of an assessee which eventually lower the tax liability to be payable.
Another tax concession in relation to housing affordability is capital gains tax discount as laid under Income Tax Assessment Act 1997/ 36. It provides a discount of 50% on the amount of net capital gain arises from the sale of properties or investment provided such asset or investment have been held for more than 12 months by the assessee (Mason & Harrison, 2015). Capital gain tax discount also enables an investor to leverage his tax liability as it reduces the taxable amount arise out of capital gains from long term assets. Further, under the ruling of case between Dickson vs. Taxation Commissioner (NSW) as decided by the High Court of Australia, it was stated that any income derived from any source shall be taxable in the hands of the assessee if such income generated in Australia and if such source is held for more than 12 months before its disposal then it qualifies for capital gain discount of 50%.
Lately, the two tax concessions i.e. negative gearing and capital gains tax discount have been a debatable issue between the media and Australian government and opposition parties for housing affordability in the real estate market. The debate is whether these tax concessions are reasons for a rise of speculative activity in real estate market, which ultimately hinders the first property investor, or whether these tax concessions are not the sole reason for a fall in owning or possessing the property by individuals. According to some reliable sources of research, in a court verdict Mr. Morrison’s claim was acknowledged which stated that the ratio of individuals who are negatively geared in the investment properties is around one in every ten as per the data of Australian Tax Office. It also showed that individuals who use the negative gearing tax concessions have taxable income below $80,000 at an average i.e. these investors have modest earnings. Some sources are of the contention that the difficulty in possessing the house property is because of demand supply inverse relation while some other sources that since the Australian Government of Taxation has introduced tax concessions on capital gain for investors, it becomes the reason for increase of speculative activity in real estate market which eventually put barriers to those who are first home investor (Gill, 2015).
From the various sources and references as well as from the points presented by Australian Taxation Office, advantages have not only provided to the long term investors in the form of tax investors but also to the individuals who are first homebuyer. The government of Australia had come up with the special loan plans, which help investors having low start up cost, lower amount of down payment, grant of loan to the qualified borrowers with low and fixed rate of interests. The government of Australia has initiated these certain advantages so that individuals can afford to buy their own home, which on the other hand stands at disadvantageous
either for other investors or for some other reasons. Some of these reasons are sanction of loan at lower limits, requirements of high insurance fees i.e. the acquirer will have to buy insurance on mortgaged as a means of security, which would be around 20% of the mortgaged security, the most disadvantage part of the entire plan is the flexibility of the plan, which is very less. The plan is obtainable to limited class of investors who satisfies the required criteria and perfect credit. Hence, it can be sum up that the benefits provided by the Australian Taxation Office are both in favour and against to the investors while the tax concessions provided to long term investors are not the only reasons for difficulties in possession of house property (Evans, Minas & Lim, 2015, September).
Section 102.5 under Income Tax Assessment Act 1997 deals with the computation and assessment of capital gain taxability that arises on sale of investments or assets that includes in the taxable income of the taxpayer. According to the provisions and regulations, there are two types of capital gain arises to the assesses long-term capital gain and short term capital gain. Long-term capital gain occurs on disposal of assets held for more than 12 months while short-term capital gain occurs on sale of assets held for less than 12 months (Blunden, 2015). For the purpose of capital gain taxability, assets include any property or shares or jewellery or cash or any other movable or immovable assets, which helps in generating income to the investor. An assessee is eligible to claim any capital loss incurred in either previous years or in current taxation year against the capital gain, assessee is also eligible to claim deduction of 50% on long-term capital gain along with certain exemptions as specified in the ITAA 1997 under section 102.5. Further, it is mentioned in the provision of Income Tax Assessment Act 1997/ 1936, that any long term capital loss incurred by the assessee in the current taxation year shal be set off with only long term capital gain of that particular current year. If the loss is carried forward to next assessment year then it can be set off against net capital gain taxable inclusive of short term capital gain.
Hence, it can be said that the provisions laid under ITAA 1997 enforced by the Australian Taxation Office is more or less at par for both the long term capital investors and for first time property buyers. However, there are some more advantages for the long-term investors (Hulse & Burke, 2015), which eventually lower their taxable amount, it cannot be said that the first time buyers face difficulties only because of the benefits given to the long-term owners. Australian government is trying to introduce and enforce new provisions, which could be beneficial to the new investors as well and once the period of holding extends beyond 12 months, they will fall under the long term investor category and accordingly eligible to claim deductions.
In this part Jai, aged 50 years, employed wishes to be retired in 20 years at the age of 70, sold his long term owned property and planning to own another, a smaller one for personal use and another property for the purpose of investment (Jacobs, 2016). For this purpose the amount of cash, he left with after the completion of sale process and repayment of home loan was $200,000.
As per the data provided, retained amount with Jai is $200,000 where as the amount of proposed loan is $150,000 at 5% per annum interest rate. The amount of interest to be paid annually is $ 150,000* 5/100 i.e. $ 7,500.
As Jai wants to take the advantage of negative gearing opportunity so that his tax liability would be in his favour, it is required to analyze all the three scenarios provided including certain necessary assumptions in consideration with the provisions of Income Tax Assessment Act 1997, under section 102.5 for assessment of net capital gain enforced by Australian Taxation Office (Hayes, 2015).
a. In the first case, Jai would be using cash of $200,000 for buying new home and loan amount $150,000 for buying property as an investment.
Under this option, annual interest on loan $7,500 is to be paid by Mr. Jai, usually the rent income is less than the interest cost and as it is not available in the case it is assumed that the rent income from the property would be around $6,000 annually (Bourassa & Haurin, 2016) which states that Jai incurs loss of $1,500. Jai is eligible to claim this loss as deduction while assessing his taxable income. Further, the value of property in future years should appreciate say, by 8% i.e. the value of property increases by $ 12,000 ($150,000*8/100) which eventually increase the value of portfolio by $10,500 ($12,000- $1,500).
On the other hand, if we assume that rent income in this case is more than the interest cost then the question of negative gearing does not arise only (Ingles, 2016).
b. In the second option, Mr. Jai would use the cash of $150,000 to buy the investment property and pay the balance $50,000 for his new home and remaining amount of $150,000 out of loan amount.
In this case, negative gearing opportunity will not arise because Mr. Jai is using the loan amount borrowed for his new home, which is not an income generating property as the asset is for self-use. Additionally, annual interest cost payable equal to $7,500 and his rental income from the investment property would be 100% taxable in his taxable income under section 102.5 for assessment of net capital gain laid in Income Tax Assessment Act 1997 enforced by Australian Taxation Office. Further, considering the appreciation in the value of property as per the assumption in the first case, amounted to $12,000 will increase the portfolio along the with rental income (Jacobs, 2016).
This Process might increase the portfolio of Mr. Jai but it will not give him the advantage in his tax liability as well as negative gearing opportunity would not be availed (Hulse & Burke, 2015).
c. In the third situation, Mr. Jai would use his cash $100,000 and loan amount $100,000 to buy home. Whereas for the investment property Jai is willing to cash $100,000 and remaining $50,000 out of borrowed amount.
This scenario is little complicated in comparison to above two options. In case of acquisition of home, Mr. Jai would be paying annual interest of $5,000, i.e. 5% on $100,000, which does not qualify for the negative gearing, as the purchased home is not an income generating investment (Gill, 2015), whereas on the investment property annual interest payable will be $2,500. As the rental income assumed in option (a), we consider the same assumption in this option as well and hence, the rental income would be $6,000 annually. Therefore, Mr. Jai incurs net gain of $3,500 and accordingly, negative gearing opportunity does not arise but the same would be taxable in the hands of Mr. Jai. However, if both the properties are to be considered then Mr. Jai incurs total loss of $1,500 while the investment property appreciates at 8% per annum i.e. by amount of $ 12,000. This option is similar to the option (b) because Mr. Jai will not be eligible to claim any deduction in this strategy and the opportunity of negative gearing cannot be availed rather the income in the form of rent will be taxable according to the section 102.5 for assessment of net capital gain under Income Tax Assessment Act 1997.
On evaluating, each of the three options above it is recommended, that Mr. Jai should opt for the first option, as his ultimate goal is to take the benefit of negative gearing opportunity under capital gain taxation along with the favourable tax recognition in the maximum in the maximum possible way (Gill, 2015). In the first option Mr. Jai is eligible to claim deductions of interest cost against his rental income from the investment property as well as negative gearing tax concession and additionally the value of his wealth would appreciate. Hence, the strategy of using his cash balance $200,000 for his home and borrowed amount of $150,000 for investment property is the most beneficial and favorable strategy among other options.
Conclusion:
This solution dealt with one of the most important debatable issue of Australia regarding housing affordability goals between the Government, opposition parties and media. Covering the different sources and concept of the Income Tax Assessment Act 1997 for investment and capital gain purpose the presentations carried the meaning, relevance and requirement of tax concession aspect for the speculative activity in the real estate market. As stated above, it is seen that the recent market structure for buying own house or property in the country has become very difficult and a great matter of concern even though there are few tax concessions and specified exemptions as presented by the Act of Income tax in Australia. As compared to the long term investors who get tax concessions on the disposal of their assets, for new and short term investors it becomes difficult to make investment and possessing house property as the market value is sweeping high while rate of income of individuals is coming down. Moreover, in the other part of the assignment, investment strategy has been carried out so as to avail the opportunity of negative gearing benefit and tax deductions and it has been concluded that the first option i.e. payment in cash for home and borrowed loan for the investment property is most beneficial option.
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