Buy, rent, or do both: the perversion of negative gearing

Other than renting, the most common way to get a roof over your head is to buy a home and live in it. Another way is to buy a home and rent it out, and then rent a similar home (buy, rent, rent). Thanks to the perverse nature of negative gearing, the buy, rent, rent strategy can be cheaper than the most obvious path of home ownership. How?

Consider a first home buyer considering a modest two bedroom, two bathroom unit in Ashfield in Sydney’s inner west for A$600,000.

Assuming the buyer has enough to afford a 20% deposit and initial transaction costs (legal fees and stamp duty, etc.), she may consider buying and living in it, or buying and investing and then renting a similar unit. She is able to borrow 80% of the unit’s value paying interest of 5% p.a (A$24,000 a year). The annual maintenance costs are A$6,000 (or 1%), deductible depreciation expenses are also A$6,000. A similar unit rents for A$450 per week. Her marginal tax rate is 34.5%. What is the cost to buy and live compared with buy, rent, rent?

Here’s an animation that shows the difference:

The first home buyer’s housing cost is A$30,000 per year if she buys and lives in the unit, and A$25,653 per year for buy, rent, rent. This means she saves A$4,347 or 0.72% of the unit price with buy, rent, rent.

The saving is solely due to the negative gearing tax savings effect. The mortgage interest, maintenance and depreciation deductions are tax deductible when investing, but cannot be deducted when living in the unit. Without negative gearing there would be no tax savings and the first home buyer would not consider such a convoluted strategy.

From the calculations, we can also see that the bigger the negative gearing tax savings, the better it is to buy, rent, rent. Buying homes with lower rent, higher maintenance costs and higher depreciation allowances (eg. new developments) and being at a higher marginal tax rate increases the incentives to do so. There is also little incentive to pay off principal in the unit as the negative gearing strategy may be done almost perpetually and any savings invested (or spent) elsewhere.

On the other hand, once the property is positively geared (when net rent exceeds cost of ownership) it no longer becomes cheaper than to buy and live. This can happen if the buyer chooses to pay off the mortgage, earns increased rent or reduces maintenance and depreciation deductions.

When it comes to selling, there may be capital gains tax on the rental property although your own home is capital gains tax exempt. Non-financial factors are that the home buyer may have a preference to live in their own home rather than to rent, despite the buy, rent, rent savings. This may be from the greater flexibility to customise your own home or not having to deal with real estate agents.

Of course, in the example renting still remains the cheapest option, though if home ownership is the goal then with the perversion of negative gearing, buy, rent, rent remains a cost effective choice.

The above scenario is just one of the many ways that negative gearing distorts housing decisions. Those on high marginal tax rates (i.e. high income earners) have incentive to invest in multiple homes. This leads to incentives to borrow excessively to invest as the negative gearing tax savings effectively reduces the ownership costs to investors compared with home owners.

Furthermore this pushes housing prices up due to the increased demand from negative gearing. Compare this to a home owner who requires only one home and is restricted in the amount that they may borrow as they do not earn rent on the home as income.

Another effect is that new homes which tend to be of higher quality are more desirable to investors as they tend to have higher maintenance costs and depreciation deductions which increases tax savings. Home owners on the other other hand are unable to deduct such costs thereby making ownership of new homes more costly than to investors.

The sooner that negative gearing is removed, the quicker simple buying and living can be the norm.

This article is for educational purposes only and does not constitute financial or taxation advice.