The Golden Rules of Tax Deductible Debt

A rational investor minimizes the after tax cost of debt used to acquire or hold an investment.

There is a strong argument that sound tax planning and sound financial planning require some clients to have at least some tax deductible debt.

Tax deductible debt is cheap money

At present some clients are borrowing money for as little as 3.85% - 4% a year.

  • If a client is in the 40% tax bracket this means the after tax rate is just 2.6% a year
  • Inflation is running at about 2.6% a year, which means the real interest rate is virtually nil.
  • In other words, once you consider tax and inflation, i.e. the purchasing power of money over time, tax deductible debt is cheap money.
Tax planning is a legitimate activity and occurs constantly throughout a client’s career. 

Tax planning is a legitimate activity and occurs constantly throughout a client’s career. 

The golden rule

The golden rule of debt management is to:

  • (i)  use your own cash to pay for your private costs, particularly interest and principle repayments on home loans and
  • (ii) use debt to pay business and investment costs where the interest is tax deductible.

Following this simple rule means you will pay off your expensive non-deductible home loan as fast as possible and minimise the after tax cost of your debt.

Negative gearing

Negative gearing occurs when the expected income from an investment is less than the cost of borrowing to acquire or hold it.

Interest rates are currently about 5% a year, if secured appropriately. This means if a share is expected to pay a dividend of 4% a year it is negatively geared, 5% a year it is neutrally geared and 6% a year it is positively geared?

Why would someone want to own a share that was negatively geared or neutrally geared?

Simple. Capital gains. A rational investor who negatively or neutrally gears an asset must be expecting a capital gain on ultimate sale. Capital gains are a great way to earn a return on an asset because:

  • if the asset is held for more than 12 months a 50% CGT discount applies (limited to individuals)
  • unrealised capital gains are not taxed
  • the investor can defer realization, i.e. the taxing point for the capital gain, to a low or no tax rate year.

So, in summary, tax breaks make negative gearing attractive to a rational investor.

The ability to claim deductions for non-cash deductions such as depreciation and building allowance increases the amount of the tax deductible loss without requiring cash outflow.

This tax deductible loss can be offset against a client’s other assessable income, such as salary income, to reduce overall tax payable. The higher the client’s tax marginal tax rate the greater the reduction in tax payable. Marginal rates are maxing out at nearly 50% right now, once Medicare and tax surcharges are factored in, so the client’s tax profile can make a good thing even better.

Alternatives

Negative gearing, and its close cousins neutral gearing and positive gearing, make sense and should be considered suitable for most people except those who are truly conservative or have a minimum holding period/time horizon less than ten years.

Individuals pay tax at a range of tax rates depending on their income level. For individuals earning an above-average income, much of that income is taxed at 37% or 45% plus Medicare levy. In addition, for the years ending 30 June 2015 to 2018, a 2% budget repair levy on incomes above $180,000 will apply.

Individuals pay tax at a range of tax rates depending on their income level. For individuals earning an above-average income, much of that income is taxed at 37% or 45% plus Medicare levy. In addition, for the years ending 30 June 2015 to 2018, a 2% budget repair levy on incomes above $180,000 will apply.


What is positive gearing?

One answer is “positive gearing is what happens after negative gearing”.

For example, one client bought his first rental property in Hampton, Victoria, way back in 1990. He was 26 years old. He is now 51 years old.

The property originally cost $80,000. $60,000 was borrowed and interest rates were 13%. It was negatively geared.

The property is now worth $800,000, has no debt and is rented for $30,000 a year. It is positively geared (or is that positively not-geared?)

More generally, positive gearing occurs when the expected income from the investment is greater than the expected interest cost.

For example, ANZ shares may have a dividend yield, fully franked, of effectively 11%. If the investor can borrow money at say 5% a year the ANZ shares will be a positively geared investment. 

Positive gearing is a great strategy, but the trick is to make sure the expected income from the investment is permanent, and not temporary.


HOW WE SUPPORT CLIENTS

At Profy Finance and Wealth, we have supported business and clients who are looking to finance commercial property assets, through:

  • Helping them get clear on their objectives
  • Ensuring financial affairs are structured effectively
  • Helping them plan for any taxation outcomes
  • Assisting in Accounting and Taxation needs with referrals to preferred accountants
  • Wealth planning, investing, and retirement
  • Arrangement and recommendation of SMSF or structures to suit their situation
  • Helping clients take an active approach to their investments
  • Ensuring Debts and Mortgages are well managed and with good providers

At Profy Finance and Wealth, we cover financial advice and mortgage & finance broking to get more holistic results for our clients. Learn more about how we could help...