I'd suggest you read S51AAA again and read carefully paras 1(b) and 1(c). Paragraph 1(c) says "if the amount had not been included in the assessable income the deduction would not be allowable".
51AAA is there to prevent you claiming a deduction that wouldn't otherwise be allowed just because you have a capital gain that an expense relates to in your assessable income in that year. An example of where S51AAA comes into play would be if you have a holiday home ythat doesn't earn any income and you have borrowed money for the holiday home. In the year you sell it you could potentially claim the interest as a tax deduction against ordinary income because the capital gain is assessable income and Section 8-1 allows you to deduct expenditure (except where capital or private) incurred in earning assessable income. Therefore S51AAA prevents you claiming a general deduction for what would otherwise be non-deductible expenditure.
However, you do have a point in that the general anti-avoidance provisions could possibly be applied against someone who never intended to make a profit from the rental, but only from capital gains. I have never heard of it happening, but I do know at least one Big 4 tax specialist who holds this view.
Also, just because people have negatively geared property investment doesn't automatically mean they are holding it for capital gain, especially in the current market. Some people hold a long-term view and acquire property with the intention that it will eventually become positively geared. I certainly did with two properties I bought. The only reason I sold them was because the rental income from one had only increased by 6% in ten years and the second had not increased in the 5 years I owned it, and also because I got fed up with useless managing agents.
Just remember if you knock out property investors deductions you would also see most share investors who borrow have their interest deductions knocked out as well.
