46 – Tax deductible debt

Introduction

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

This is a general proposition that applies to every client presentation. For example, it’s a reason to not recommend margin lending. The interest rate will be higher and therefore the after tax return on the investment will be lower. A cheaper form of lending will be in the client’s best interests and more appropriate to the client.

Minimizing the real after tax cost of debt is necessary to maximize the real after tax return on your client’s investments. And if you do not do this your advice is not in your client’s best interests. Which is a problem.

When is interest deductible?

Interest is deductible where the purpose of the borrowing is to generate assessable income.

The critical word is “purpose”. How do you prove purpose? Paper proves purposes. In this case purpose is proved by looking at the application of the borrowing and what it was really used for. The courts have often looked at the question of purpose, in the context of whether interest on a loan is tax deductible against business or investment income. You can get an idea of the scope of their enquiries by perusing  ATO Taxation Ruling TR 95/25, which can be accessed here: ATO Income Tax Ruling TR 95/25.

It’s a good idea to create and retain a clear paper trail showing the deductible purpose. This paper trail should be long and detailed, including for example the original e-mail to your bank manager to get the ball rolling, the formal loan application, the loan documents and all other documents created in connection with the loan, and as result of the loan.

Tax deductible debt is cheap money

At present some clients are borrowing money for as little as 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, ie the purchasing power of money over time, tax deductible debt is cheap money.

What should you do? What should you tell your clients?

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

The ASX Russell Long Term Investment Report 2015 shows that Australian shares and property both averaged more than 9% a year over the twenty years to 31 December 2015. This means most people who borrowed money to buy Australian shares and property over the last twenty years benefited, ie they earned more on the investment than it cost to borrow the money. Nothing is certain but, in summary, it is probable that in the next twenty years most people who borrow money to buy Australian shares and property will earn more on the investment that it costs to borrow the money.

The trick is to know which shares and property to buy, and to have the discipline and prescience to look twenty years ahead and not change tack at the first sight of market turbulence or disruption.

Most clients borrow for most things

I was chatting with Adam, a Dover adviser. We were discussing Eve, a new client Adam met while holidaying in Eden (NSW). Adam said Eve was quite well off and had just paid cash for a new parcel of shares. I looked at Eve’s fact finder and noticed she had a $200,000 home loan. It was not much. And her home was worth well over $600,000. But it was still a loan.

I observed Eve had in effect borrowed to buy the shares. Adam said no, Eve would never do that. Eve could do no wrong. She had made it clear she never borrowed for investments.

I pointed out that whenever someone has any debt that person in effect borrows every time they spend any money at all, whether it be a pint of milk, a new shirt, a new car or a parcel of shares. They have in effect borrowed because the could have used their cash to pay off the loan, and then borrowed back.

The counterfactual creates an effective reality. And means they have in effect borrowed.

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 minimize 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:

  1. if the asset is held for more than 12 months a 50% CGT discount applies (limited to individuals)
  2. unrealized capital gains are not taxed
  3. the investor can defer realization, ie 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.

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

What is positive gearing?

One answer is “positive gearing is what happens after negative gearing”. For example, one financial planner bought his first rental property in Hampton, Victoria, way back in 1990. Was 25 years old. He is now 50 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.

The Dover Group