Search

Gearing undergoes a renaissance

THE crackdown by the Australian Tax Office on agricultural investment schemes has led to a renewal of interest in gearing as a tax minimisation strategy.

Gearing is a tried-and-true technique for investors to minimise their tax and gain increased exposure to investment markets.

Gearing involves individuals borrowing against their existing assets so that they can purchase additional income-producing assets, typically shares or property. By using ‘other people’s money’, indiviuals can increase the size of their investment portfolio.

A second major benefit is that the interest expense is tax deductible. This feature, along with the ability to pre-pay interest prior to June 30 (in order to get a higher tax deduction), explains why many high-income individuals on the top marginal tax rate are attracted to gearing.

Alliance Investment & Retirement Services’ Brad Martyn said there was a high degree of flexibility in the way individuals could approach gearing and, therefore, it could be designed to suit most circumstances.

One of the key issues is the level of gearing. He recommends a 50:50 mix of debt and equity. That is, investors should contribute $1 of their own money for every dollar they borrow.

Put another way, if an investor already owns, say, $20,000 worth of shares, they can borrow a further $20,000 to purchase additional shares

Alternatively, if an individual has focused on paying off their housing loan, they can use the equity in their home as the basis for building an investment portfolio.

They could borrow, for example, $30,000 from their bank to purchase a portfolio of shares or managed funds.

With these assets as security, they could borrow a further $30,000 from a margin lender such as Leveraged Equities or BT Margin Lending and acquire additional shares.

Mr Martyn said investors needed to recognise the risks involved in gearing. The risks included an increase in interest rates, which would make it more difficult to meet the interest expense.

This is especially so when individuals employ negative gearing, where the interest payments exceed the investment income.

(Positive gearing applies where the investment income is greater than the interest expense. In this case, there is no tax advantage but the investor can still benefit from having a larger portfolio.)

Another risk is that the value of the investments will fall, potentially to the point where the margin lender will make a ‘margin call’. In this case, the investor will have to repay some of their debt or provide extra assets as security. In practice, this often means the investor will have to sell some of their assets in a falling market, which is precisely when they would not want to sell.

Mr Martyn said that, sticking to a 50 per cent gearing level was an effective way of avoiding margin calls, even though margin lenders will generally lend up to 70 per cent of the market value of blue-chip shares and managed funds.Leveraged Equities illustrates the relationship between gearing and risk by taking an individual who invests solely in blue-chip shares.

If the investor is geared at 50 per cent their portfolio would have to fall by 33.3 per cent before a margin call is made.

If they are geared at 70 per cent (the maximum level permitted by Leveraged Equities) their portfolio only has to fall by 6.7 per cent before a margin call is required.

Mr Martyn strongly recommends that individuals should view geared investments in shares as a long-term (seven to 10 year) proposition. Shares are inherently volatile in the short-term and gearing multiplies the effect of both rising and falling markets.

He also urges geared investors to stick with quality investments, instead of borrowing to invest in speculative stocks.

n Contact Mark Beyer at mbeyer@vianet.net.au

Add your comment

BNIQ sponsored byECU School of Business and Law

Students

6th-Australian Institute of Management WA20,000
7th-Murdoch University16,584
8th-South Regional TAFE10,549
9th-Central Regional TAFE10,000
10th-The University of Notre Dame Australia6,708
47 tertiary education & training providers ranked by total number of students in WA

Number of Employees

BNiQ Disclaimer