No doubt you’ve heard of negative gearing in terms of property investment. But property is not the only way to reap its benefits.
Put simply, gearing involves borrowing money to invest and it can be an effective method of accumulating wealth. This article looks at some of the key considerations and strategies for you to consider when entering a gearing arrangement.
First, consider your taxation implications
When determining the correct structure for your gearing strategy, it’s important – and wise – to consider the tax consequences and benefits. In fact, I would advise that it is a crucial part of assessing whether a gearing strategy is right for you.
One benefit of a negative gearing strategy is the ability to maximise tax efficiency by reducing an owner’s (individual or otherwise) taxable income as a result of the losses incurred. That is, when expenses are greater than the income generated by the investment. If there is no, or minimal, taxable income to offset, the benefits of this strategy are reduced.
As an example, let’s consider a Discretionary Family Trust (as opposed to an individual) holding a property. While this structure may have benefits, such as asset protection and estate planning, it will not provide the greatest taxation benefit if the trust does not have a taxable income to benefit from the losses generated by the negative gearing strategy.
Now let’s compare a property owned personally by an individual who has an income of $200,000 p.a. (excluding rental income) to that of a property held in a Discretionary Family Trust that does not generate any other income. The difference from a tax benefit point of view is approximately $10,000 on a $550,000 property.* While there are other factors to consider, this does show the importance of understanding why you are structuring your assets and debt in a particular way.
Margin loans: a good approach – with caution
In addition to property investment, negative gearing strategies can be used to invest in other assets classes such as shares and managed funds. With such investment investors may consider using a margin lending facility as opposed to using borrowing for example secured against property holdings.
While this strategy presents the opportunity to increase your market exposure for a given initial investment in a tax efficient way, it’s not without its own risks. Be aware that when you enter a gearing strategy with a share portfolio, the risk of a margin call is real. A margin call can occur when you enter a margin loan arrangement (to purchase assets in a geared portfolio). The lender will require you, the borrower, to maintain an agreed maximum loan to value ratio (LVR). But unlike property, the value of a share portfolio can be tracked in real time. While this can be great if you are watching your portfolio grow, it also results in live updates of your LVR. If your portfolio falls below a given value as a result of a market downturn (or a negative return of a particularly large holding), you will be required to provide additional equity, cash or equivalent generally by 2pm the following business day or within 48 hours This is a margin call. If you cannot produce the required funds, you will be required to sell investments within your portfolio to reduce the outstanding loan balance and LVR. Being forced to sell investments during a period of negative returns means if investments recover you will have crystallised a loss and will not remain invested to benefit from this.
So, while negative gearing with a share portfolio can be a successful wealth accumulation strategy for the right candidate in the right situation, due diligence, preparation and understanding of the associated risk is key for this to work successfully.
Other gearing options
Instalment warrants are another gearing alternative. These allow you to gain exposure to a variety of underlying assets with the leverage built in and with limited recourse – the most you can lose is your initial investment. Managed funds also have offerings that allow the potential for higher returns with the borrowing structured within the fund. As with other geared investments, the geared nature does impact the fund’s volatility. It’s important to determine what is right for you so you will feel confident in what can be a complex environment.
Smarter property investment
When it comes to the structuring of assets and liabilities, property is usually a key holding that requires careful review. An often overlooked consideration is the benefits of an offset facility for your own home beyond reducing your mortgage interest charged.
Yet, a common mistake investors make when purchasing their principal residence is placing additional funds back onto their mortgage with the view that these funds can be redrawn later. If you plan to use your current property as an ‘investment property’ once you purchase your dream home, or even if you plan on renting out your current property during a stint overseas, there can be tax consequences. If you do not have an offset account, any extra payments you have made to reduce your interest charged could either be tied up as capital repayments or held in a redraw facility – where if redrawn the interest payable may not be tax deductible. By using an offset account instead, the funds can be readily available and used to reduce the non-deductible debt of the new home loan rather than being used to reduce the deductible debt of the investment property.
*Assumptions - property value: $550,000, loan: $500,000, loan period: 30 years, interest rate: 4.5% (interest only), rent: $19,500 p.a., total expenses: $28,475p.a. (loan repayments: $22,500, council rates: $775, strata: $2,400, insurance: $800, land tax: $0 (below threshold), repairs and maintenance: $2,000) and property depreciation: $10,000.
If you would like to speak to an Avant financial adviser about your personal circumstances, you can do so by calling: 1800 128 268 or by scheduling an appointment
** Taxation, legal and other matters referred to in this article are of a general nature only and are based on an interpretation of laws existing at the time of first publication and should not be relied upon in place of appropriate professional advice. Those laws may change from time to time.
Any advice here is general advice only and does not take into account your objectives, financial situation or needs. You should consider whether the product is appropriate for you and the Product Disclosure Statement for the relevant product, available by contacting us on 1800 128 268, before deciding to purchase or continuing to hold a policy or plan. Information on this site does not constitute legal or professional advice, and is current as at the date of initial publication.