News that some banks are no longer taking into account the tax benefits of negative gearing in loan applications has thrown the strategy back into the spotlight.
The tax breaks from negative gearing are often a key consideration in terms of making the numbers stack up on a property investment, but one-size does not fit all. Given that property is a long-term investment, a negative gearing strategy is a “moving target” that will depend on an individual’s tax position, and other factors, over the life of the investment.
If the property market takes a turn for the worse, financial advisers who have recommended highly-geared strategies could potentially become the target of investors who suffer a loss on their investment. The duty of care owed by financial advisers when providing negative gearing property advice was highlighted in a recent determination by the Financial Ombudsman Service (FOS) reported in Thomson Reuters Weekly Tax Bulletin (Issue 7, 17 February 2017).
In that determination, a financial services business was ordered to pay $70,000 in compensation in relation to negative gearing property advice provided to a husband and wife client. This followed a finding by the FOS panel that the adviser had breached its duty of care by failing to adequately explain the risks of its negative gearing advice.
The husband and wife applicants received financial advice to roll over their existing superannuation and change their insurance arrangements. They were also advised to purchase 2 vacant blocks of land for development into investment properties for rental income. The Statement of Advice (SOA) had classified the applicants as “assertive investors” based on a financial needs analysis of their household expenditure. On balance, the FOS said it was reasonable to classify the applicants as assertive investors given their attitude to risk.
The recommended property purchases were funded using interest-only loans of $917,000 with a loan-to-value ratio (LVR) in excess of 100%. A real estate company related to the financial services provider was responsible for the choice of property. The property projections provided to the clients had assumed 5% capital growth and rental valuations of $430pw and $450pw for each property. One year later, the actual rents obtained were $380pw and $370, respectively.
Negative gearing advice found to be inappropriate
While the superannuation and insurance advice was found to be appropriate, the FOS panel determined that the negative gearing and property advice breached the duty of care to the applicants. The FOS considered that the negative gearing strategy and explanation of the risks did not meet the standard of care a reasonable person would expect from the financial services provider.
The FOS considered that the negative gearing strategy exposed the applicants to a level of risk that was well beyond that of their risk profile. The FOS noted that neither the SOA nor property projections alerted the applicants to the impact on their financial position if the properties fell in value, or the rental income was lower than projected. Likewise, the documentation did not alert the applicants to their exposure in the event of a local economy downturn or an oversupply of housing.
The FOS also found that the recommended strategy resulted in the applicants incurring a level of debt that magnified their risk and threatened their objective of reducing their home mortgage. In this respect, the FOS said that the adviser undertook insufficient analysis of debt affordability, and instead relied on a bank calculator to determine the maximum amount that a bank would lend them.
Tax benefits of negative gearing
While a highly-geared strategy can generate significant tax benefits for a high income earner being taxed at the highest rate (45% plus Medicare levy in 2013), the FOS said this was not the case for the applicants. The husband had a marginal tax rate of 32.5% (plus Medicare levy) while the wife’s was 37% (plus Medicare levy). As such, the FOS found that the property investment analyses did not assess their after-tax cash flow situations using their individual tax rate. Instead, the property investment analysis was done based on the applicants’ joint position and included a “tax credit (joint)” using a tax rate of 45%. The FOS ruled that the after-tax cash flow figures presented in these documents were misleading.
Finally, the FOS determined that the financial services provider should pay $70,922 to compensate the applicants for their loss. This amount of compensation was determined as the difference between the total contributions/outgoings and the benefits received in relation to the properties.