How tax system changes could cut house values


Wed, 16 Dec 2009 3:44p.m.

Westpac economists taking a stab at the impact of possible tax changes on house values reckon the decline could be as high as 34 percent.

In a note today, Westpac chief economist Brendan O’Donovan and research economist Dominick Stephens focused roughly on tax changes being discussed by the Government’s tax working group.

The economists acknowledged their estimates were sensitive to the assumptions they made, but said the framework was useful for illustrating that prices would be affected by taxes, and for giving a rough guide to their size.

According to the exercise, the biggest impact would come from the introduction of a deemed rate of return of 6 percent. The result would be a fall of between 26 percent and 34 percent in house prices, while rents would rise between 13 percent and 17 percent.

For property investors, rental income would not be taxed, and expenses including interest would not be tax deductible. Instead, income tax would be applied to a “deemed rate of return” on the net equity on the property. Owner-occupiers would be unaffected.

Under the deemed rate approach, fully leveraged landlords would not pay any tax on their zero equity, but would lose the right to deduct cash losses on the property against their taxable income.

The Westpac economists reckoned that the introduction of a 10 percent capital gains tax would lower house prices 15.7 percent and cause rents to rise 7.8 percent. But they regarded a capital gains tax on investment property as unlikely, saying it would be costly to administer and much of the burden would fall on tenants who tended to have low incomes.

A reduction in the top rate of tax to 30 percent would see house prices fall 13.6 percent and rents rise 6.8 percent, the Westpac economists estimated. Landlords received a tax rebate for losses on their rental properties at their marginal rate of income tax.

If the marginal rate of income tax changed, so would the size of the rebate. A land tax of 0.5 percent was estimated to cause house prices to fall 4.4 percent and rents to rise 2.2 percent. The fall in house prices was based on the median house, for which land made up 40 percent of the value. Land values were estimated to fall 11 percent. Under a land tax of 0.5 percent combined with income tax of 30 percent house prices would fall 16.9 percent and rents rise 8.4 percent.

The Westpac economists said such a combined approach was “politically plausible”. They were unable to work out how far prices would fall under a ringfencing scenario under which rental losses could only be offset against future rental profits, not current personal income. There would be no ability to shelter from income tax using loss-making rental properties, but property would still be a tax-efficient investment for cashflow positive landlords.

Owning property came with tax advantages, Mr O’Donovan and Mr Stephens said. An investment in one’s own home incurred zero tax on the flow of benefits — avoiding rent and capital gain. By contrast, all other investments incurred tax on the interest/dividends/profits.

From a rental property perspective, the losses from paying more in expenses and mortgage interest than receiving in rent were tax deductible against other income, while capital gains were tax free, the economists said. “High-income landlords can swap their taxable labour income for tax-free capital gain income. Unsurprisingly, many do.”