GearingGearing is simply another term for borrowing to invest. While we may not enjoy being in debt, not all debt is bad. In fact, it can be a powerful tool used to build wealth and to enhance your investment performance.
Many of us have borrowed at one time or another for our larger purchases, like a holiday or a car. However, when done sensibly and with careful planning there are cases when borrowing to invest can be even more worthwhile.
Gearing occurs where an investor borrows money to invest, which is generally secured against either the investment or an alternate asset, such as the principal residence.Gearing can be attractive because under current Australian taxation laws, you may be able to claim a deduction for interest and expenses, which can be offset against assessable income, such as salary, business income or investment income.
Gearing is a sophisticated investment technique and is not suitable for everyone. Before you embark on any gearing strategy, we recommend you contact one of our Certified Financial Planners (click here) to discuss the merits of gearing for your personal circumstances.
Positive or negative?
Positive gearing is when the interest payments and other investment costs are lower than the income you receive from the investment. Example: borrowing to invest in shares when the dividend income exceeds the expenses of the loan.
Negative gearing is when the interest payments and other investment costs are higher than the income you receive from the investment. Example: negative gearing on a rental property occurs when the interest payable on the loan used to purchase the property plus other expenses (maintenance, etc) exceeds the rental income generated by the property.
Negative gearing occurs when the income received from the investment is less than the interest incurred on the loan. The total amount is deducted from the investor’s taxable income in the financial year incurred, which effectively reduces the other assessable income for the investor in the same period. Negative gearing reduces your day-to-day cashflow, as you are intentionally making an investment knowing that the income you earn will not necessarily cover the ongoing costs involved.
Investors are able to gear investments into direct shares and property as well as managed funds and unit trusts. Rental property investments pay income in the form of regular rent and direct shares pay dividends in line with company profits. Similarly, property trusts, sharemarket funds and other unit trusts generally distribute income paid from the underlying investments either quarterly or half-yearly. However, unlike a rental property, managed investments are generally more attractive for gearing for the following reasons:-
- Deposits and ongoing investments can be in a smaller quantity and arranged as regular instalments;
- Maintenance issues are not the direct responsibility of the investor but the investment manager;
- Pooling of funds allows for smoothing of tenancy problems and other risk factors;
- Investments are professionally managed;
- The investment is more liquid and cheaper to redeem;
- The complete investment does not need to be redeemed, with the ability to downscale the amount invested.
Investors in the higher marginal tax brackets achieve a greater tax advantage due to the reduction in tax payable from the deduction. This generally assists in providing greater long term benefits.
The benefits and risks of gearing
Like all investment strategies, there are both benefits and some risks associated with gearing.
• Gearing can be attractive because under current Australian taxation laws, you may be able to claim a deduction for interest and expenses, which can be offset against assessable income, such as salary, business income or investment income.
• Gearing allows you to increase your ability to create wealth by enabling a higher level of investment than would otherwise be possible. In a favourable market your earning potential can be multiplied.
• If you choose to invest your geared funds into selected shares, the dividend imputation system (DIS) will result in you receiving a tax credit on the dividends you collect (known as ‘franked dividends’) and, therefore, being accountable for only a small amount of tax on this income. This can actually have a positive effect on your cash flow.
• Assets may not always provide the returns you expect. You should only borrow to invest if you expect the investment itself will be producing genuine, decent returns somewhere down the track.
• If you over-extend your borrowing, rising interest rates could restrict your ability to meet loan payments.
• There may be periods where your investment provides little or no income, or even losses.
• Gearing can multiply your losses.
• Should you wish to sell a geared asset and pay off your loan earlier than expected, penalties may apply.
• You may be forced to sell in an unfavourable market.
Other Things to consider
Tax on selling your investments:If you sell your investments for more than you paid for them, you’ll have a capital gains tax liability. This will be a maximum of 46.5 per cent but if your investments are held for 12 months or more, due to the capital gains tax discounting, this will be halved. Another way to minimise this is by waiting to sell your investment until your tax rate is lower, such as when you retire.
Margin calls apply when you borrow via a margin lending arrangement. A margin call is when the market worth
of your security falls. The result is the loan-to-valuation ratio (LVR) exceeds the allowance limits. In this situation you will usually have three options:
1. Deposit additional securities that you have
2. Pay back part of your loan, and/or
3. Sell your portfolio and draw on the profits to pay back part of the loan.
Your gearing loan provider will generally need the LVR to be returned to the arranged limits within a stated time period, usually within 24 hours. Although, when you borrow less than the maximum loan limit, you can decrease the risk of margin calls.
Gearing may not be suitable for all investors. Whilst it can lower your tax liability, the tax implications will depend on your personal situation as well as your attitude to risk and the type of investment chosen. You should always seek qualified financial advice.To find out more or to determine the suitability of gearing to your financial situation, please contact Adviser fp (click here)