Tuesday, May 31, 2011

Landlord selling? Looks like you're free to go *

The new Residential Tenancies Act 2010 has now been in operation for five months. Regular visitors will recall that this Act marks the first comprehensive rewrite of renting laws in more than 20 years - fixing many flaws in the old 1987 Act, and bringing a few new measures in to reflect the changing of the times.

As with any new piece of legislation, what's written down by Parliament can mean different things to different people. It's only when disputes under a law are taken into the judicial system for arbitration that we can start to properly understand that law's meaning - because the courts generally get the last word on how to interpret a law. In the case of the
Residential Tenancies Act, the first port of call for arbitration is the Consumer, Trader & Tenancy Tribunal (CTTT). Although decisions made by the CTTT do not set legal precedents (in fact it is not even bound by its own decisions), for the purposes of understanding how fiddly bits of our new renting laws work, we need look no further than decisions made in the CTTT.

Not all CTTT decisions make it into print, and there's often a lag as most juicy decisions take time to write up and publish. But luckily for us, we've got access to the collected works of the Tenants Advice and Advocacy Services, so we can spot 'em as they happen.

Recently, the CTTT decided a case that helps to clarify part of the new law*. At section 100(1)(c) the Act allows tenants to give notice to end a tenancy during a fixed-term (without having to compensate the landlord) - if the landlord tells the tenant that they're going to start selling the property. But there's a catch... the landlord must not have already told the tenant about the proposed sale before the tenancy began.

And, maybe, there's another catch. Another section of the Act - s26(2)(a) -
requires a landlord to tell the tenant about a proposed sale before entering into a residential tenancy agreement (specifically, if a contract for sale has been prepared).

Until now, it has been unclear whether this would mean that tenants could not make use of the s100(1)(c) option, unless the landlord had failed to disclose an already existing intention to sell before entering into the agreement. In other words, if a landlord had no intention to sell at the beginning of the tenancy (and therefore had nothing to tell the tenant), could they later change their minds, and would this prevent the tenant from giving notice under section 100(1)(c)?

Tenants' advocates have formed a view on this - that the two sections of the Act can be read independently of one another - and this has now been successfully argued in the CTTT. In the case of
Kutzner v Kamp (NSWCTTT unreported) the Tribunal stated:

The issue for determination is whether in these circumstances the tenants were entitled to give notice of termination under section 100(1)(c) of the Residential Tenancies Act 2010. I am satisfied that it is not a requirement of this provision that the landlord must have an intention to sell the property at the time of entering into the residential tenancy agreement which was not disclosed. It is only necessary for the landlord to have notified the tenant of such an intention during the fixed term without notice prior to commencement of the tenancy. "Disclosure" in the sense used in s100(1)(c) does not mean disclosing what was known to the landlord but rather whether prior notice had in fact been given of the landlord's subsequent decision.

The question arising upon the Tenant being told of the intention to sell, is whether the Tenant had been told at the commencement of the tenancy that this would happen. It is not an answer to say that the landlord did not know then that this would occur.

This is a good outcome for tenants, but we'll be keeping an eye on how landlords respond to it. Will we start to see blanket disclosure under section 26(2)(a)? Presumably, not all prospective tenants will be keen to enter into agreements on properties that are listed for sale, so even if landlords do start to try this on, we don't think it will take off. Most landlords wouldn't want to limit their pool of potential tenants in this way. Even so, if you're sitting down to sign a new lease and the agent says "oh, by the way, we need to tell you the landlord is going to sell, but it's nothing to worry about because they haven't listed it yet", it would be a good idea to press them for more information. If they can't give you any indication of when a listing for sale is likely to proceed, there's a good chance you'll be able to distinguish - when it matters - between what was known to the landlord then, and any subsequent decision to sell.
* This information is not to be construed as legal advice and should not be relied on in the making of any rash decisions about moving house. If in doubt, contact your local TAAS.

Friday, May 20, 2011

NSW State Govt dumps affordable housing policy

Reported in today's Herald:

THE Planning Minister, Brad Hazzard, has called an immediate halt to new development applications made under a controversial policy designed to boost affordable housing for low- and middle-income-earners, and announced amendments to the scheme while a new policy is developed.

We understand the 'controversial' policy to be the Affordable Rental Housing State Environmental Planning Policy (ARHSEPP) - or, at least, those aspects of the ARHSEPP that deal with 'infill affordable rental housing'.

(There's no word in the report or, as yet, on Planning NSW's website as to whether other aspects of the ARHSEPP, such as those dealing with boarding houses, supportive accommodation, or developer contributions to compensate for the loss of affordable housing, have been changed.)

The Herald quotes Minister Hazzard as saying the infill affordable rental housing provision gave ''an avenue for small-time developers to rip into local communities and change [their] entire face''.

We submit that unaffordable housing also rips into local communities, by forcing essential workers like nurses, police officers and teachers to live far away from their places of work, and by forcing out residents who might have deep roots in a community, but not deep pockets.

The Tenants' Union supports the ARHSEPP, but with some pretty heavy reservations. It doesn't - and to be fair, couldn't - address the primary causes of unaffordable housing, which lie in the tax system, rather than the planning system. (It's not as if housing is unaffordable because low-income renters have been too greedy as to the standards required of their bedsits).

But even on its own terms, the ARHSEPP is a policy instrument of marginal usefulness. This is because its approach is basically permissive: it allows certain things to be done that, under the usual rules applied to developments, wouldn't otherwise be allowed to be done, provided they're done to provide affordable rental housing. It doesn't require or mandate that anyone do anything about affordable housing.

If the State Government will not pursue the provision of affordable housing outside the usual rules for developments, it's going to have to do so within the rules. That means mandating substantial quotas of affordable housing for major developments, and requiring all local councils to plan for affordable housing.

Wednesday, May 11, 2011

The Henry Review reviewed: part 2

In part 1 of our review of the Henry Review, we looked at tax and owner-occupied housing. This time we're looking at tax and rental housing – but before we do, a bit of news.

You'll recall the Federal Government's promise to convene a tax summit, at which the Henry Review may get a second lease on life. Now a date has been set – 4-5 October 2011 – for what's to be called the National Tax Forum. Pencil it in, readers! You can get up to speed and keep up to date by checking out the excellent TaxWatch website – and, of course, the Brown Couch's own continuing review of the Henry Review.

(Ken Henry (at right), with Treasury officials in sportive mood.)


In a universe parallel to our own, the story of rental housing and tax might be a simple one: rental properties are valued as assets that produce a valuable service – housing – and owned by persons with the necessary skills to make a viable business out of providing this service; the revenue of the business covers its costs and provides an income for the owner, which is taxed, and if the assets increase in value, the gain is taxed too.

For a picture of how differently things go in our own universe, consider the following charts. The first shows the number of persons who have become landlords (or more precisely, persons who declare rental income in their tax returns) – which grew strongly over the last decade-and-a-half. It also shows the proportion of them declaring a rental loss – and this grew strongly too.

(Source: ATO Tax Stats Chapter 2 – Personal Tax, various years)

And let's look at their losses, in dollar terms. In 2008-09, the most recent year for which we have figures, Australia's landlords took in rent revenues of more than $26 billion – but after their costs, ended up losing $6.5 billion. Since the turn of the century – the last time they actually made money from rents – the nation's landlords have lost more than $36 billion.

(Source: ATO Tax Stats Chapter 2 – Personal Tax, various years)

And these were rental property's boom years (that uptick in 2008-09 is the result of some landlords bailing out in the GFC). What's going on?

Negative gearing, that's what's going on. Negative gearing is financial alchemy, turning losses into gains – or rather, at an elemental level, turning income into capital.

More prosaically, negative gearing is the name given to the situation where an investor borrows to buy an asset and the interest they pay is greater than the revenue generated by the asset. They get into this situation with the hope or expectation that for all the losses they have to wear along the way there will be a greater payoff at the end – that is, through an increase in the value of the asset.

Other names can be given to this strategy: 'speculation', or 'gambling.' The Henry Review calls it another form of savings, like putting money in the bank is savings, and putting money into owner-occupied housing is savings. This is, in our view, an undeserved compliment to negatively geared rental property speculation, but it does give us some common points of reference with the 'bank saver' and 'owner-occupied housing saver' from part 1 of our review and a way of thinking about how negative gearing works, so once again we'll work with Henry on this.

Here's how the alchemy works. Start with the negatively geared landlord's gross income: rental income from the property, and income from other sources – namely work. All the rental income goes on interest and other deductible costs, and a far bit of their other income – in total, $6.5 billion of it – goes on those costs too. There's no tax payable on the rental income (because in net terms, it is wiped out by costs) and – under a provision of Australian tax law that is almost unique internationally – there's no tax payable on that other bit of the landlord's income too.

By contrast, our bank saver only puts their money away after the tax office has run its eye over all the saver's income and taxed it accordingly; likewise our owner-occupied housing saver puts their money into the house after it has been taxed. With the negatively geared rental property saver, the money is put towards the cost of the loan before it is taxed, thus reducing taxable income and possibly even the rate of tax. It is as if the income they spend on interest etc melts into air, before the taxman's very eyes.

Or so it seems. It reappears as the value of the property it has bought increases, transmuted into capital. And when the property is sold and the capital gain is realised, it does get taxed (contrast the income from the owner-occupied saver's capital gain, which is not taxed at all) – but it gets taxed at half the rate applicable to income from work.

Now, there's a golden rule to be observed here: the negatively geared rental property saver makes a profit only the after-tax capital gain pay-off at the end of their speculative adventure is more than the total income lost to interest etc along the way. Satisfaction of this rule is helped a lot, of course, by only half-taxing the capital gain, and by the fact that the landlord paid no tax on the income that was spent on interest, and may have paid a lower rate of tax on the rest of their income.

And it has also been helped a lot by the fact that they are using, as the crucible of their alchemy, the housing market. A person can (and quite a few people do) negatively gear other assets, such as shares, but when it's housing, they're trading in a market alongside owner-occupiers who, as we've seen, don't pay tax on capital gains and so are encouraged to put any money they have to spare into housing. Thus the tax-preferencing of owner-occupation is also an encouragement to speculation by landlords, and encouragement to speculation is encouragement to further speculation, even to the extent that the speculators begin squeezing out the owner-occupiers – which, prior to the GFC at least, is precisely what was happening in the Australian housing market, as evinced by declining rates of home ownership.

Henry presents a neat graph showing the results of the different tax treatment for each of the savings strategies we've discussed (it also includes superannuation, domestic shares and foreign shares). The results are presented in terms of effective marginal tax rates – in other words, how much each additional dollar of income from these savings actually gets taxed, with reference to the various marginal tax rates that apply to incomes generally.

(Click on the image for a better view. Graph based on Treasury assumptions of 6 per cent nominal return; 2.5 per cent inflation; for rental property, 50 per cent of the return is attributable to capital gain and 50 per cent to rental income and the rental property is held for 7 years then sold; shares are held for 7 years then sold; superannuation is held for 25 years and the individual is eligible for a tax-free payout at the end of the period.)

On these assumptions, pity the tenant diligently putting their spare dollars away into a bank account, rather than borrowing and spending on a house.

In a second graph of effective marginal tax rates, Henry zeroes in on the rental property saver category and shows how crucial negative gearing is to the success of their strategy. More than that – it shows how crucial is the level of gearing (that is, the proportion of borrowed money in the landlord's purchase of the property).

(Click on the image for a better view. Graph based on Treasury assumptions of 6 per cent nominal return; 2.5 per cent inflation; for rental property, 50 per cent of the return is attributable to capital gain and 50 per cent to rental income and the rental property is held for seven years then sold; tax on debt provider disregarded.)

The more debt, the more income melts into air, the more tax is reduced – all subject, though, to the golden rule above. 'This creates', Henry says, with some understatement, 'significant distortions in how rental properties, in particular, are financed and for the rental property market.'

And how! Just look at the huge growth in the debts of landlords (and, for good measure, owner-occupiers):

(Click on the image for a better view. Source: RBA Table D2)

All that money, pumped into higher prices.

(Australian capital city house prices, index. ABS cat no 641601 and 641603)

And look, too, at how landlords spend their borrowed money: pursuing gains in tried and tested housing markets, on established houses and flats. These speculators barely build any new stock.

(Click on the image for a better view. Source: RBA Table D6 - note lending commitments are not aggregated, unlike debts in Table D2).

So how to address the sources of these distortions in tax system? One way would be to put an end to the Australian oddity and allow interest etc to be tax deductible only against rental income. This way no more of a landlord's income from work and other sources would disappear before it is taxed, and the golden rule of profiting from rental property would apply a sterner test of value. This is TaxWatch's preferred reform, and as we saw in the articles referred to here, Saul Eslake advocates it too.

The Henry Review proposes something different. In keeping with his theme of making the tax treatment of the various forms of saving more consistent, Henry would reduce the favourable treatment of capital gains by lowering the capital gains tax discount from 50 per cent to 40 per cent. He'd also even up the treatment of rental income, by applying a 40 per cent discount to it (net of interest etc), too (as he would to interest income from bank savings, as we saw in part one). Negatively geared landlords could still deduct interest costs from their non-rent income, but the effect of applying the discount on a net rental income basis would reduce the extent to which interest costs reach into non-rental income and reduce taxable income.

Henry indicates the results in a chart contrasting the current approach to his proposed one, again in terms of effective marginal tax rates and using the same assumptions as before.

(Click for a better view.)

This is, so to speak, a proposal for watering down the alchemy of negative gearing. It is, to use Henrian understatement, a mild reform.

Next: housing transfers – that is, rent rebates in social housing, and rent assistance in private rental.