Will Labor Cause a Housing Crash?
Given that current polling points to a change of Federal government in 2019, it’s timely to consider Labor’s policies and how they may affect property investors.
To help separate partisan politics from financial fact, I was recently joined by Julian Cheng, Tax Director of Pitcher Partners (a national accounting firm) on an insightful webinar. Some of the topics discussed during that webinar form the basis for what’s written in this article, but note the interpretation and special commentary is mine, not Julian’s.
Liberal Party’s Smoke & Mirrors Tax Cuts
Before we discuss Labor’s policies, I feel it important to first comment about the Liberal party’s next to useless (at least for buy and hold property investors) yet much-trumpeted company tax cuts.
Lowering the rate from 30% to 27.5% (and promising further reductions from there), the Liberal party is attempting to show it is pro-business. When you look at the detail though, it’s not what it first seems.
How so? Well, in order to qualify for the lower company tax rate, you have to be within certain turnover thresholds (not a problem for most private investors), and can only have a maximum of 80% so-called ‘base rate entity passive income’. Given rent and net capital gains are included as passive income unless there is other income that the company earns, the income will still ALL be taxed at 30%. Thanks for nothing!
For instance, let’s say BBB Pty Ltd owns commercial property worth $1om, and those are its only assets. Given all company income comes from rent, it will be taxed at 30%, not 27.5%.
In fact, you might actually end up paying more tax under the Liberal party’s sham company tax cuts because of the way dividends are franked! Julian provided the following example that explains how that might happen…
The first column is how things would be at a 30% tax rate. No problem. However, once at 27.5% tax in the example provided, the taxpayer will end up paying more income tax in his or her own hands, despite the company tax rate being lower. Doh!
Source: Julian Cheng, Pitcher Partners
The only way to sum this up is to call it out for what it is: a dud policy.
Despite many pleas and submissions, it seems this is what we are stuck with, and doubly so, as Labor has said they will keep the lower tax rates for companies in place now (although it will not reduce them further).
Labor Policy 1: Negative Gearing
Turning our attention now to Labor’s proposed policies (remember, they are not currently in Government), the standout policy would appear to be their desire to change the rules about negative gearing.
Negative gearing allows an individual taxpayer who owns a loss-making property to offset that loss against other taxable income (like salary and wage income), thereby lowering their taxable income, and hence their annual income tax payment. Presently, all properties – new and old – qualify to use negative gearing if the circumstances say so (i.e. property expenses are higher than property income).
Labor is proposing to only allow negative gearing on new properties. For pre-existing residential properties, any loss cannot be used to offset non-investment income but rather will be quarantined and carried forward to offset future investment gains, either when the property becomes profitable or when it is sold and there is a capital gain.
Personally, I think the intention here is quite good. As a principle, loss-making taxpayers who speculate on property should not have their activities underwritten or subsidised by taxpayers. Why should the government subsidise an investor’s second, third or fourth property when so many people can’t even own one? That said, I think the application of that policy is going to be problematic.
A good precedent that points to what will probably happen is to recall the events leading up to the introduction of the First Home Owners Grant (FHOG) in the year 2000. After announcing the policy several months before it was to begin, many buyers (who were to qualify for the FHOG) delayed their buying until after the FHOG began, thereby creating a ‘demand vacuum’ in the meantime. That caused prices to temporarily fall, before bouncing back quickly once the FHOG started, when there was a lot of demand and a comparative shortage of houses.
Applying such hindsight to what might happen with Labour’s negative gearing change, if the ‘beginning date’ is known ahead of time then it could pull forward a lot of demand as people buy up those properties that qualify for negative gearing while they still can. Then, once the new rules begin, there could be a substantial drop in values of second-hand dwellings targeted at investors (see below).
The safest thing Labor can do is to bring the change into effect on either the date they are elected (relying on the fact that everyone ought to know they were going to make the change) or else on budget night.
I believe the biggest losers will be those who buy a new negatively geared property after the change comes in, as, while they will be able to claim the loss, they will probably take a hit to their resale value since whoever buys it from them later won’t be able to claim the loss (as the property will now be second-hand).
Consider Rebecca. She owns a flat which is built for student accommodation. She bought it as a negatively geared property in the hope it will appreciate in value so that the capital gain will exceed the sum of the annual income tax losses. This type of property will be less attractive after the rules change because the person buying it off Rebecca will not be able to offset the loss (from the property’s expenses being higher than its income), and so it will thus become less affordable (since the loss will need to be funded in pre-tax dollars). Instead, buyers of student accommodation will prefer new properties that do qualify to be negatively geared. The outcome must be an increase in the price of new properties (since the demand will be focussed there), and a decrease in price of second-hand properties (as sellers discount the selling price to provide the same after-tax outcome).
This is unlikely to cause a crash (see my concluding comments), but it will cause a redistribution of wealth and create winners and losers.
Note that Labor has said they will grandfather any existing properties, meaning that those who own an investment property before the rules change can still offset the loss against their other income. That might theoretically entice people to ‘hold on’ to negatively geared properties longer than they otherwise would, and cause a shortage of houses for sale (thereby putting upward pressure on rents and property prices). A possible fix for this is to give people a finite period to sell, say three years, before pre-existing properties lose their eligibility for negative gearing too.
Labor Policy 2: Halve the CGT Discount
Given Labor trumpets about allocating more money to welfare, education and health, in order to fund their projects, they’re going to either have to increase existing taxes, make up new taxes, and/or remove some of the existing perks. On the radar is the capital gains tax (CGT) exemption.
In case you don’t know, the CGT discount was the brainchild of Peter Costello to make the GST more palatable. He did away with indexation (i.e. adjusting capital gains for inflation) and replaced it with a blanket 50% capital gains tax (CGT) exemption for individuals, and a 33% CGT exemption for Super Funds (nothing for companies), who owned a property for at least a year. It’s worth remembering that the introduction of GST was supposed to coincide with the reduction and eventual dismantling of stamp duty – something that never happened. Grrrrrr!
In hindsight, this has proven to be poor policy, as it contributed to inflating asset values, including housing. Think about it… those who negatively gear can offset 100% of their losses, and only pay tax on 50% of their gains? What a great deal!
A point I keep making over and over again is this: a blanket 50% CGT exemption that you qualify for after 12 months skews investing to favour near-term projects.
Consider Investor A. He owns the property for 13 months during an upcycle, sells it, makes (say) $100,000, and gets $50,000 of that profit tax-free. Investor B buys a property on the cusp of a down market, owns it for 5 years while the market recovers, then sells it and makes $100,000 profit. She too gets $50,000 tax-free, but her profit is worth less in after-inflation terms because an amount of $50,000 in 5 years time buys less than $50,000 today.
The flawed principle is this: the longer you own a property, the more of the gain pertains to inflation which you will have to pay tax on.
Imagine Investor C. He buys a property, owns it for 5 years, then sells it for $50,000 more than he bought it for. After all in and out costs, he makes a $20,000 profit. Half of it, $10,000, is tax-free. The other half is taxed, however in after-inflation terms, he probably hasn’t made any money at all.
The conclusion: unless the property market keeps going up, and up, and up, many taxpayers will end up paying income tax on profits they didn’t really make!
And you guessed it… reducing the CGT exemption to 25% is going to make this situation even worse.
Then there is the dislocation that comes from companies not being eligible for the CGT discount at all, enticing people to use trusts. This is a problem because of Labor’s proposed changes as outlined below.
The simple fix, albeit politically unpalatable, is to just say we can’t afford the CGT discount any more (because we want to increase the unemployment allowance, fund hospitals, schools, the NDIS, etc. etc.), and just revert back to the old indexation rules (the latter always was a far more equitable system for all concerned).
Naturally, pensioners will be upset about their middle-class welfare being snatched away, but realistically, that’s how we will be able to afford to pay their pensions and hospital bills. It is unfair to burden younger taxpayers with that cost. Don’t hold your breath though.
Labor Policy 3: Trusts
Labor is proposing that unless you qualify for an exclusion (farms, charities, etc.) then those who receive a trust distribution will be subject to a minimum income tax of 30%.
Think about all those structures that utilise trusts as an income splitting mechanism to legally (I repeat legally) minimise tax. And not just investment trusts, but medical practices and many, many small, medium and large family businesses.
If this one goes ahead there will be a ‘financial earthquake’, and accountants are going to become very, very busy rejigging family and/or business and investment empires.
Labor Policy 4: Imputation
Finally, Labor is planning to tinker with how people claim franking credits.
Briefly, imputation stops shareholders being taxed twice on company profits, by giving them a credit for the tax paid by the company. Without a franking credit a company would pay tax, and then shareholders would pay tax a second time on dividends they received from after-tax company profits.
Prior to reforms instigated by Howard and Costello, if the company paid more tax on your share of their profits than you would have had if you earned the money in your own right, then you simply ‘lost’ the difference. Today though, you get a refund.
What is happening is that taxpayers who have a marginal tax rate less than the company tax rate receive a ‘refund’ of the overpayment of tax that the company essentially paid on their behalf. Forget about lowering the tax rate… many shareholders pay little or no tax on their dividends at all!
Once again, in hindsight, this was poor policy. It has only served to inflate the prices of companies paying comparatively high dividends, and effectively allow (some) shareholders to pay little or no tax on their share of company profits.
Returning imputation back to the way it was is a good and fair reform. The present situation is a largesse we can’t afford, although it will be difficult to pry this middle-class welfare entitlement out of the hands of those who have become reliant upon it.
So, Will Labor Cause A Property Crash?
Circling back to the question at hand, will these new Labor policies cause a property crash? No, I don’t think they will. A situation where you have a large number of forced sellers due to the unaffordability of their mortgages (because interest rates increase, or they can’t refinance as they expected, or because they lose their jobs, etc.) is much more likely to cause a house price correction (or crash).
What Labor’s policies will do though is to trigger a redistribution of wealth, and in doing so, there will be many winners and losers. I’ll be keeping a close eye on final policies and, once known, I’ll write more about it to try to help you understand and navigate your way through the changes.
What Do You Think?
Well, that’s my say. What do you think? Or if you have any questions, post them below, and I’ll do my best to reply.