Prime Time Financial Counsellors Pty Ltd: Practical issues

Practical issues

Lender requirements
Lenders for geared share or managed share fund facilities may want to assess:

Your ability to meet interest repayments; and
The security that you can offer.

Your income, either from employment or other investments, may need to be disclosed.

In the case of a margin lending or installment gearing facility, the security for the loan is typically the investments themselves. This is why lenders will impose a percentage limit on how much they will advance against any given asset.

For a home equity loan, your home constitutes the security, so the lender will take a mortgage over the property. With your home as the loan security, it is clearly sensible to take a fairly conservative attitude with this type of facility.

Ownership of investments
Under most gearing arrangements, the ownership of the investments, including any existing investments used as security, remains with you as borrower. This not only ensures that you are entitled to the dividends and franking credits, but also means that you receive all the other entitlements of ownership, such as reports, voting rights, discount cards and other shareholder benefits.

It is usually possible to invest in an individual name, in joint names, or in the name of a trust or company. Otherwise, you should aim to own the investment in a way which delivers the best after-tax result. This will depend on your individual circumstances and on the current and prospective returns for the investment.

As a general rule, if the investment is expected to generate a negative cashflow for a lengthy period, it may be better to hold it in the name of a high rate taxpayer, who can gain the greatest advantage from the potential tax deductions. An investment which will quickly become cashflow positive may be best owned by a low rate taxpayer. Your financial adviser can help you assess the taxation implications of gearing.

Whilst the ownership issue is crucial to the success of a gearing strategy, and issues other than cashflow may also be important. You should always take independent legal and tax advice to determine the most appropriate arrangement for you.

Fixed or variable interest?
Most lenders offer a choice of variable or fixed interest rate loans. Sometimes a combination is available, with the flexibility to switch from one to the other.

Variable rates are subject to change at short notice. The main advantage they offer is flexibility. They usually allow you to vary your repayments, and to make "one-off" repayments without penalty.

The main advantage of fixed rates is certainty. The rate is generally set for a period of up to 5 years, which protects you from any unexpected increase in interest rates and makes it easier to plan ahead. However, fixed rate loans are generally less flexible, so you may not be able to vary repayments or make extra payments with penalty.

Claiming tax deductions
Interest is generally deductible in the year in which it is paid. Some investors choose to pay their interest monthly in arrears and, if they have funds available as they approach 30 June, pre-pay the following year's interest. A deduction can usually be claimed for up to 12 months' interest paid in advance.

Most investors will claim their interest deductions in their annual tax returns. However PAYG taxpayers do have the option of applying for the deduction to be received progressively through the year. If the Tax Office gives its approval, you can have your employer reduce the tax deducted from your regular salary payments. This procedure needs to be approached with care, because a mis-calculation can lead to penalties.

Taxation of capital gains
As we have already seen, a gearing strategy should always have as its key objective the creation of a capital gain. For so long as the investment is held, that capital gain will only exist on paper. At some stage, however, the investment may need to be sold and the gain realised. This may be part of the original plan, for example if the investment was to pay for a specific future expense, or it may become necessary to allow for the balance of the loan to be repaid.

Because of this focus on capital gain, the operation of capital gains tax (CGT) is of particular importance to geared investors.

CGT applies when you sell or otherwise dispose of an asset (except for certain excluded assets such as your home and motor vehicles).

Discount method of calculating CGT
On 21 September 1999, the capital gains tax rules changed and a new method for calculation of a taxable capital gain was introduced.

All capital gains of assets held for at least 12 months are now eligible to be reduced by the CGT discount, which is 50% for individuals. These are called discounted capital gains.

The discount can be applied only where an asset is held for at least 12 months. The discount method must be used for all assets that were purchased on or after 21 September 1999.

(Old) indexation method
For assets purchased up to 20 September 1999 and held for at least 12 months, you can use either the discount method described above or the old indexation method. Broadly, under the old indexation method, the capital gain is calculated by deducting the cost base from the sale price. The cost base is the original cost base indexed to account for inflation. Note, however, that indexation of the cost base is frozen at 30 September 1999.

Planning for capital gains
If you are likely to make substantial capital gains, it makes sense to do some planning. Some of the options to consider are:

Avoid having to realise the gain, by making sure separate assets are available to pay off any remaining borrowings;
Offsetting gains by realising losses in the same financial year;
Arranging sales to occur in a year when your income is relatively low, so the gains are taxed at a lower tax rate.

Planning for capital gains
If you are likely to make substantial capital gains, it makes sense to do some planning. Some of the options to consider are:

Avoid having to realize the gain, by making sure separate assets are available to pay off any remaining borrowings
Offsetting gains by realizing losses in the same financial year
Arranging sales to occur in a year when your income is relatively low, so the gains are taxed at a lower tax rate.

Geared share investments can involve a variety of tax issues, including interest deductions, negative gearing, capital gains and franking credits. For these reasons we strongly recommend that you obtain professional tax advice that is specific to your individual circumstances.

Reproduced with the kind permission of Macquarie Margin Lending