23 July 2010

Build wealth with borrowed money

If you want to build your wealth in a tax-effective manner, borrowing to invest could be the answer.

By using the above strategy, you can:

  • make a larger investment than if you relied exclusively on your own capital, and
  • claim the interest on the loan (and certain other expenses) as a tax deduction1.

Also, if the investment is negatively geared (ie the deductible expenses exceed the income you receive), you can use the excess deductions to offset other sources of taxable income.

What are your options?

There are a number of ways you could borrow to invest and the best approach will depend on the type of asset you want to buy and your specific circumstances.

For instance, if you want to borrow to invest in shares, you could use a margin loan where shares (or other approved assets) are used as loan security. This security could be provided by yourself or a third-party, such as a related company.

You could also use existing shares as security for a margin loan to borrow for business or other investment purposes. This option could be appealing if, for example, you're a business owner with a sizeable share portfolio and no other 'tangible' assets that could be used as loan security.

Another way to gear into shares is to borrow against the equity in your home. As you pay down your mortgage, you could then periodically increase the amount you borrow against your home and build an even bigger share portfolio.

This strategy, known as debt recycling, can enable you to:

  • progressively convert your non tax deductible home loan into a tax deductible investment loan, and
  • acquire more shares to help build your long-term wealth.

If you're a member of an employee share scheme, you may want to:

  • sell the shares when they reach the end of the cessation (vesting) period
  • pay down your home loan
  • redraw the money through an investment loan, and
  • purchase other2 investments to add more diversification to your portfolio.

These are just some of the clever ways you could borrow to invest tax-effectively to grow your wealth and achieve your goals sooner.

What about gearing in super?

If you have a self-managed super fund, your fund could borrow to purchase certain assets such as shares and property. This could enable your fund to acquire assets it currently doesn't have enough cash to purchase outright.

For example, if you're a business owner, your fund could consider buying your business premises. This property could then be leased back to you or the entity through which your business is run.

There are, however, some significant differences between gearing in super and gearing in your own name. One key factor is that greater restrictions apply when gearing in super, including caps on contributions. It's also important to consider whether the investment will be positively or negatively geared.

As a general rule, gearing in super can be more tax-effective if the investment is positively geared (ie the income from the investment exceeds the loan interest and certain other expenses). This is because the excess income will be taxed at a maximum rate of 15% in the super fund, rather than your marginal tax rate.

Conversely, negatively geared investments can be more tax-effective if held in your own name. In this scenario, you'll receive more value for the excess tax deductions than a super fund would if your marginal tax rate exceeds 15%.

But even if an investment is negatively geared at the outset, borrowing in super may still be a better option. This is because negatively geared investments can become positively geared over time.

Also, regardless of whether the investment is positively or negatively geared, less capital gains tax will generally be paid on the sale of the investment if it is held in a super fund.

Consider the risks

Regardless of whether you borrow to invest within or outside super, gearing can enhance your losses if your investments fall in value.

For gearing to be successful in the long term, the investments purchased with borrowed money need to generate a total return (including income and capital growth) that exceeds the after-tax costs of financing the investment. It’s therefore essential that:

  • quality investments are selected, and
  • you have enough time (and a sufficiently high risk tolerance) to ride out the inevitable market ups and downs.

Advice and support

To find out whether gearing suits your needs and circumstances and which approach you should use, it's important you seek financial advice.

A NAB Private Wealth adviser can help you make these decisions and identify a range of other strategies to grow and protect your wealth.

To find out how this strategy could work for you talk to your Private Client Manager.

1 To be eligible to claim the interest on an investment loan (and certain other expenses) as a tax deduction, the investments you acquire with borrowed money need to generate assessable income.

2 If you sell an asset, recycle the proceeds through your home loan and borrow to buy back the same asset, the Australian Taxation Office may consider this a scheme to obtain a tax benefit and seek to apply penalties and deny your interest tax deduction.

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