My wife, being South African, finds a number of things about Australian culture strange. Friends turning up at your house and eating your food whenever they feel like it, for example. Or special security guards in pubs making sure you don’t drink too much. In South Africa, she says, that is the point of going to the pub.
But the strangest thing about Australia is its obsession with tax losses. Perhaps biased by my father being one of the first locals she met in this country, she finds it odd that he has spent his whole life running a farm at a loss just to avoid the tax man. We are not alone – the Germans love a good tax dodge too – but, to her, it is unbelievable that someone is prepared to spend more than $1 million on a house just so they can “negative gear” it. In South Africa, you buy houses where the rent is more than the interest payments. Again, she says, that is the point of an investment – it generates you income.
It’s not quite that simple. Historically, negative gearing has been a very effective strategy. Interest rates included an inflation component that was deductible upfront and taxable as discounted capital gains well into the future.
When inflation was 5%, say, you could buy a house on a 5% rental yield, fund it with debt that costs 8% and expect to do very well. You run at an annual income loss of 3% initially, but the value of the house is growing at something like 7% per annum, 2% real plus the 5% inflation. That 7% growth more than offsets the 3% losses, and you don’t pay tax on it until you sell the property.
Negative gearing is a strategy that works best in a high inflation world.
So why is it still so popular when inflation is just 1-2% per annum and at risk of going lower? Well, I’m going to have to side with the wife on this one. It’s popular because people love a tax deduction, but it no longer makes economic sense. I know, I know, you are going to tell me property prices are going to keep going up forever and you don’t need to worry about yield.
But that is speculation. From a pure economic standpoint, paying 4.5% interest on a property that yields less than 2% doesn’t make any sense in a low- or no- inflation environment (or, shudder, a deflationary environment). Negative gearing is no longer a strategy. It’s an obsession. My guess is people will get sick of it without the government changing a thing.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.