How do negative gearing, capital gains tax and trusts work?

A tax shake-up is coming. Next week’s federal budget will include changes to the capital gains tax, negative gearing and the rules for trust funds.

All three were part of Labor’s 2019 election campaign. Back then, it argued that the tax concessions were unfair and benefited “the top end of town”. This time, the Albanese government will frame it as a policy to help young people access the housing market.

As is always the case when tax is debated, the proposals are likely to be contentious and the devil will be in the detail. Some of those details are not clear yet, but a picture is emerging. Here’s what you need to know.

How negative gearing and the capital gains tax work

Negative gearing and the capital gains tax apply to a range of financial assets, including shares, but their most common use is for investment properties. In combination, they have made property a popular form of wealth management for Australians.

A negatively geared investment property is one that makes a loss, typically because the mortgage payments and other costs are higher than the rental income. Those losses are tax deductible, not just against investment income but against ordinary income.

Negative gearing has been possible for nearly a century, but it became more popular after 1999 when the Howard government made the capital gains tax discount more enticing.

Capital gains tax is paid when an asset is sold. The “gain” is however much the asset has increased in value since it was purchased, with some adjustments.

Under the original system set up in 1985, the gain was taxed as part of a person’s ordinary income tax, but a discount was available for however much of the gain was due to inflation, on the grounds that this should not be taxed.

But in 1999, this was replaced with a 50 per cent discount, with half the gain taxed as income and half the gain untaxed. In practice, this is often an “overcompensation” for inflation except when properties are held for a very long time, justified on the grounds that it would encourage investment.

From the perspective of someone deciding where to put their money, the important fact is that it makes investment properties or shares more attractive than some other common options such as an interest-bearing bank account, which is taxed without any inflation discount.

That makes investment properties a tax-effective option for many people, with or without negative gearing. But if the property is negatively geared, there is the added benefit of reducing tax today, not just down the track when the property is sold.

Each year the property is negatively geared, the owner pays less income tax. They are also making a loss, but have usually been able to rely on the fact that their property will gain enough in value that they can make that back upon sale, taxed at a discount.

Who benefits from negative gearing and the capital gains tax?

In 2022–23, the last year for which we have data, 1.2 million investment properties were negatively geared (roughly half of all investment properties) and 1.1 million people made a capital gain.

In general, those most likely to benefit have high incomes and high asset wealth. Those in the top 10 per cent of income earners received 83 per cent of the benefit of the capital gains tax discount in 2022–23, and 37 per cent of the benefit of negative gearing.

Treasury officials have previously warned that income is not the best way to judge the distribution of the benefits of capital gains tax, in particular because people typically move up the income scale in the year they make the gain.

Wealth may be a better measure, because it captures assets rather than fluctuating income. It is difficult to assess how much of the benefit flows to the wealthiest Australians, but any person with multiple properties is likely to be among the wealthiest.

A household with net wealth of $2 million would be in the top 25 per cent, and a household wealth of $5 million would be in the top 5 per cent.

Much of this result is because a small handful of people have very large property portfolios and so enjoy substantial benefits.

But there are many people who are not at the top of the scale who negatively gear. Roughly two-thirds of those who negatively gear have one investment property.

The same is true for age. While older people are most likely to negatively gear, there are 150,000 people in their 30s who do so.

This cohort may include so-called mum and dad investors with one property, and so-called rent-vestors who own one home, rent it out and rent for themselves elsewhere.

Overall, the federal budget “lost” $3.9 billion in revenue in 2022–23 from negative gearing and $23.5 billion from the capital gains tax discount.

What changes are expected to negative gearing and the capital gains tax?

In 2019, Labor proposed to eliminate negative gearing for future investments, except for newly built homes. Pre-existing investments were exempted from the new rules, a practice called “grandfathering”.

The capital gains tax discount was to be halved to 25 per cent for all assets, again with grandfathering.

This time, it has been speculated that Labor is more likely to revert to the pre-1999 scheme of making the discount equal to the amount of inflation, but it may also consider a flat discount such as 25, 30 or 35 per cent.

For negative gearing, Labor could opt to abolish it entirely or to cap the number of properties that can be negatively geared.

In both cases, grandfathering is likely. But for the capital gains tax changes, partial grandfathering may be considered. For instance, by taxing gains from the past at 50 per cent and gains in the future according to inflation.

Another uncertainty is whether the proposal will exempt new homes, so that Labor can argue its policy is actively encouraging supply by pushing investors towards new stock.