How to Halve the Amount of Tax you Pay

Although most readers will know that gearing can be used to increase returns (and risk) of an investment, some may not be as familiar with the benefits of gearing as a tax reduction* tool. This aspects of gearing means that even when rising interest rates make gearing facilities such as margin lending appear unattractive, in reality they can still be a core component of your financial plan. The fact that long term capital gains (ie. a capital gains tax event occurs more than twelve months after an asset is purchased) are taxed at half your marginal tax rate is the key to understanding how this works.

Take, as a example an ungeared investment of $100,000 in a share fund (returning 3% dividend income and 5% capital growth) vs. the same investment increased through the use of a margin loan for the same amount, with an interest rate of, say 6%. Marginal tax rate is assumed to be 30% and dividends fully franked. Net value is calculated at the end of a "typical" year:

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$6,000.00
Inc Tax      -$1,285.71      -$771.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $110,300.00

As expected, where the margin loan interest rate (6%) is less than the total return (8%) from the investment, gearing increases your gains.

What is interesting though, is that gearing is still beneficial when the interest rate on the loan is as much as the total return on the investment (8%):

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$8,000.00
Inc Tax      -$1,285.71      -$171.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $108,900.00

This happens because the use of gearing is effectively 'converting' taxable income into taxable capital gains, which provides a superior after tax return.

Of course gearing also magnifies any losses, so this "tax effect" is only a consideration if you are reasonably sure the total return on your investment will be at least match the cost of funds borrowed over the long term. For this reason I prefer to use margin lending to fund a diversified share portfolio, preferably with a core holding of an index fund.

It's also important to be reasonably conservative in your gearing levels so that normal market volatility and 'corrections' won't trigger margin calls. Although it's hard to correctly 'time' the market, it's probably also prudent to reduce gearing levels when the market is well above it's long term trend line, and thereby have some spare borrowing power available to add to your investments at the end of a bear market if the index is well below it's long term trend. It's also worth shopping around to find the best interest rate available for a margin loan, as there can be a significant difference between lenders. It's also worth reading the fine print, as you may be able to negotiate a reduced rate on large loan balances. For example, I get a slight discount on the standard margin loan rate from St George margin lending as we have a large home and investment property loan with them and thus qualify as 'gold' customers.

* I use the term 'tax reduction' as it seems to be the most acceptable terminology to use these days in regards to tax planning. Although tax evasion is illegal and tax avoidance/tax minimisation is, by definition, legal, there has been a trend towards vilifying and legislating against "tax minimisation schemes" and "tax avoiders". On the other hand, politicians on both sides revel in passing laws to facilitate 'tax reduction' through reduced tax rates, increased thresholds or expanded deductions, so it seems to be the PC term to use in relation to paying as little tax as possible.

Copyright Enough Wealth 2007