Can leveraging up on a loss-making investment be a winning strategy? This note – part of a series on the capital gains tax (CGT) discount – focuses on the leverage distortions previously noted by investigating data on housing investments.

Recent e61 work describes three economic distortions of the CGT discount – inflation, timing and leverage. By examining the individual rental income and capital gains returns for 900,000 housing investments held over 2008 to 2025, this note demonstrates how and why the CGT discount encourages investors to borrow more than they otherwise would.

Ultimately, the discount treats capital gains and interest expenses unevenly, which means that investors can borrow to turn a loss-making investment into a positive after-tax return.

Key findings

• For typical investors, the tax rate on overall housing returns declines as an investor’s debt increases. This occurs because the tax paid on capital gains is less than the tax deductions on the higher interest costs. 
• Investors have incentive to leverage when their rate of return from rental income and capital gains, adjusted for inflation, exceeds their mortgage rate.
• For about 3–5% of housing investments, this was only true because the CGT discount artificially boosted returns.
• This incentive for leverage most likely increases the price of housing and pushes households into a less diversified and more highly leveraged portfolio.

Reducing the discount or limiting interest claims associated with negative gearing (i.e. ring-fencing) would partially address this issue. However, other approaches can remove it entirely, including the cost-base adjustment for both revenue and interest expenses as described in the note, What are we discounting for? Thinking through CGT reform options utilising property data.