In Australia we are fortunate to have a tax system that encourages personal investment through the ability to claim tax deductions for investment expenses. Many Australians have taken advantage of this through the purchase of rental properties which allows the claiming of tax deductions for certain expenses such as interest payments. Borrowing to invest in the share market through margin loans and gearing has also become increasingly popular as it provides more liquidity and diversity of investment choices. However, as with any investment strategy, the investor needs to do their research and understand the potential risks and returns before blindly chasing tax deductions.
The success or failure of this investment strategy depends on several fundamental rules;
Important rules to follow
•The focus of the investment should be long term capital growth with the end return being significantly higher than all after tax expenses.
•The tax deductible investment expenses should be more than the income received in order to reduce taxable income.
•Investments should be kept for at least 12 months in order to benefit from the 50% reduction in Capital Gains Tax upon sale.
•A risk premium should be factored into calculations. This should be based on the probability of the investment’s success however should be at least the current risk free cash rate.
What are the variables that affect the strategies success?
•Current and future interest rates
•Returns on the investment
•Investor’s marginal tax rate
Who is this investment strategy best suited for?
•Those in the higher tax brackets.
•Those with surplus income which can be used to fund investment costs.
•Those with a medium to long term focus (ie. 5 years +) who do not require a return on their investment for a number of years.
•Those with a medium to high risk tolerance who can endure market fluctuations without panicking.
Is now a good time to start this strategy?
Ultimately this strategy works best when the costs of borrowing (interest rates) are lower than the expected long term return on investment. At the moment in Australia interest rates have fallen dramatically and are expected to reach historically low levels by mid year. The share market in 2008 experienced massive falls which has seen even large blue chip companies become very cheap in relative terms. With high earnings yields and historically low Price to Earnings ratios now evident, commentators are saying that a high level of value has returned to the market. The long term return of the share market is around 10-15% p.a. so if you can borrow for less than this and benefit from tax deductions at the same time, this strategy is an excellent way of building wealth in the long term. De Run Financial Solutions will be running a number of seminars on using this strategy as a tax planning tool as we head towards the end of the financial year.
Mark Wingate B.Bus, Dip. FP
Financial Planner
De Run Financial Solutions
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