Gearing, Diversification and the Tax Arbitrage

Many Australians are well aware of the benefits of borrowing (also known as gearing) into residential property. People associate borrowing to invest in residential property as providing tax and growth benefits.

What is not as well known is that gearing into shares or managed funds, provides similar benefits with some additional advantages.

Gearing works on the principle that if you can earn a better after tax return on borrowed money than it costs you by way of interest, and you can manage the risk involved, then it becomes an attractive proposition. Used well, gearing can accelerate your capacity for wealth creation because more money is being used to invest. With gearing you have a greater share of the investment pie working for you in the market place funded by borrowings and tax savings.

Diversification
Many Australian investors are heavily overweight in the residential property sector. One of the great advantages offered by funds and listed investments is that of diversity. Investors can invest into shares, listed property trusts, floating and fixed income securities and a whole array of Australian and international managed funds. This diversity offers greater security and protection against the vagaries of any particular market sector. Importantly a geared portfolio should be directed more to the growth sectors with the aim of achieving growth at a higher rate than the cost of borrowing.

The Tax Arbitrage
One of the other key advantages of gearing into shares or funds comes from the tax treatment of those investments. Most blue chip Australian companies pay a high level of franked dividends. This essentially means that the dividend has a tax credit which the investor can use to offset against their tax.

The other key tax advantage for individual investors is the 50% CGT exemption. If the investments are held for over twelve months then only 50% of the capital gain is taxable.

With property trusts a percentage of the income distributions are tax free or deferred. Ultimately this increases the amount subject to Capital Gains Tax on sale but this can be reduced by 50% after twelve months as mentioned above. This essentially means what would otherwise be fully taxable income is converted to capital gains that are only partially taxable after twelve months.

This is a great tax story. For most investors the interest costs and ongoing adviser fees are tax deductible whereas only a part of the gains are actually subject to full tax. The impact this benefit has on compounding growth is substantial.

Margin Lending
A popular method of gearing into shares or funds is through margin lending. A Margin Loan is a flexible line of credit to invest in shares or managed funds that doesn’t require your family home as security. This means the borrowing is secured against the investment portfolio. In the same way that property investors put down a deposit and borrow the rest, a Margin Loan allows you to buy a significant investment portfolio with as little as a 20% deposit. We usually recommend an equity level of around 50% but it can be as little as 20%. The equity can be in the form of cash, shares and managed funds or a combination of all three.

Flexibility
As mentioned above, Margin Loans are flexible. This means that you can also invest in regular instalments, rather than simply a lump sum amount. This is known as Instalment Gearing and incorporates a regular automated facility in which you save, borrow and invest each month so that you gradually increase your total investment. So each month you can elect to borrow a minimum of $250 and contribute $250 of your own portfolio, increasing the investment to $500 per month. This lets you benefit from dollar cost averaging, which helps to smooth out the volatility (or risk) of your investments over time.

Example
Here is an example that illustrates the multiplier effect of using a margin loan by simply increasing the amount of money invested. The following example illustrates the performance of a share portfolio with and without gearing over the last 20 years to January 2004 (based on All Ords Index).

• Initial investment (Ungeared) - $50,000
• Initial borrowing - $50,000
  

Why Use Gearing?
You may want to consider margin lending if:-

• Have lots of wealth tied up in property and want to diversify into shares and managed funds.
• Want to build a strong portfolio of managed funds, but don’t have the necessary capital.
• Want to accelerate wealth creation by investing a combination of your own money and borrowed funds.

Risks and Advice
As illustrated above, Margin Loans have many benefits but there are also risks involved. They are not suitable for everyone so it is important to receive financial advice if you are considering such a strategy. If you’re interested in learning more about whether you could benefit from a gearing strategy, contact Brendan Gallagher at Financial Keys to have a chat. You may be surprised by the result.

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CENTRELINK and Redundancy Windows Closing
-ACT NOW

Proposed legislative changes to the treatment of “Complying Pension Investments” and “Redundancy Payments” prompt the need for a strategy rethink and timely advice.

Complying Income Streams Asset Test Exemption
Currently retirees can invest some or all of their superannuation benefits into “complying pensions” with the effect being that this investment is not counted for Centrelink Assets Test purposes. Recently the Federal Government announced that from 20 September this 100% exemption will be reduced to 50% for complying pensions purchased after this date.

The Government has expressed concern that this exemption has enabled people with “significant assets” to claim an age pension. The removal of this 100% exemption after September 20 is a major change. In recent times retirees have been rolling over some of their funds from allocated pensions to complying pensions so as to become eligible for the Age Pension. The effectiveness of this strategy is about to be substantially reduced.

Retirees with allocated pensions or those contemplating retirement have until 20 September to implement strategies under the old rules. We recommend that you contact your adviser if you believe you are affected by these changes.

Market Linked Pensions
From 20 September, there will be another complying pension available to retirees – market linked pensions. Like existing complying pensions they will have significant tax and Centrelink benefits (although the Centrelink benefit will be halved). The key difference is that investors can have investment choice and can invest in a diversity of growth assets. In the past complying pensions were always invested in the lower yielding fixed interest and cash sectors. In essence market linked pensions will be a hybrid of the existing allocated pension and the existing fixed-term or lifetime complying pension.
These new Growth Pensions should be contemplated by those that:-

• Have a substantial superannuation portfolio and are seeking to qualify for the Pension RBL.
• Currently have or are seeking the Age Pension and who will benefit from its 50% asset test exemption.

Used correctly with other retirement vehicles such as allocated pensions, they can provide substantial benefits to retirees. Balancing the need for liquidity, tax minimisation and in some instances maximisation of age pension, the new market linked pensions provide another string to a retirees bow.

Redundancy Changes
From 1 July 2004, redundancy payments where part of the payment can be paid either as cash or as a rollover to a superannuation fund, will be preserved if rolled over. Until this time, when this payment is rolled into superannuation, it can be withdrawn at any time.

Redundancy is often an area where an individual is not necessarily aware of the consequences of their decision to rollover their payment or take it in cash. The tax rules on payments, surcharge implications and from 1 July the accessibility issues make redundancy payments an area where the right strategy can provide substantial benefits and the wrong decisions can cause plenty of headaches. Seeking advice in this area is crucial.

Recently a Financial Keys client advised that their role with their company was to be made redundant in June 2004 after more than 15 years working for the company. He initially was thinking about taking all of the employer payment in cash so that he could pay some of his mortgage and other liabilities. The consequence of this was a hefty tax bill and several months down the track, a bill for surcharge.

After reviewing the payment details we were able to advise that taking some of the employer payment in cash and rolling some of it into his superannuation account was a better result. By rolling over a significant portion to superannuation and delaying the withdrawal for one year until age 55 the client was able to save thousands of dollars in tax. This strategy will allow the client to repay some of his mortgage and expenses, reduce his tax bill and he will be able to access his payment from his superannuation fund next year!

If you or someone you know is being made redundant, it is important to seek financial advice to ensure a good understanding of the options available. In this way an informed decision can be made.

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MARKET Commentary

World political events and fears impacted many overseas markets over the quarter. There has been mixed results from the major economies.

It is hoped that strong Chinese economic growth will be tempered with the recent Chinese government announcement that it would be taking measures to slow down investment in the fastest growing areas. European indicators were not so positive, with consumer spending (particularly in Germany) being quite sluggish.

Business confidence in Japan is improving, with the optimistic outlook now shared by large and small Japanese firms. Japanese exports are growing and domestic demand is showing signs of improvement which is positive news for Japan but also for global demand and growth.

As shown in the graph below, Japan’s NIKKEI has performed well over the past three months.

Other parts of Asia were less fortunate with falls in Hong Kong and Thailand. These markets remain leveraged to US economic activity and sentiment.

In the US, concerns over potential interest rate rises have put the brakes on stock market growth with major indices being flat for the quarter. This is despite strong profits being reported by US companies. In early May the US Federal Reserve Bank announced that rates would not rise at the present time however it did note that if it were to lift rates in the future it would be at a “measured” pace.

In domestic news, the housing market continues to cool, with the rate hikes from 2003 having an impact on growth. The Australian sharemarket was stronger during the quarter (to 30 April), with many companies reporting for the period showing profit growth. Over the past few months, US and Chinese economic growth combined with positive domestic economic news and good company profit results (particularly from insurance companies) have fuelled the growing Australian share market. The graph below shows the performance of the All Ordinaries Index over the past three months.

Looking forward the following figures from Van Eyk Research indicate a positive environment both locally and globally over the next 18 months, though not like what we’ve seen over the past 12 months. Resources will continue to be strong as world growth picks up and as China’s ever increasing demand continues to put pressure on prices. This is good news for the Australian economy and points to a continued strong Australian dollar.

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NSW Property Investors Handicapped

It seems the negativity surrounding the residential property sector is not about to end soon. The recent NSW mini budget has delivered a blow to property investors that adds to the wider gloom felt by many holdin residential investment properties.

Many investors are rethinking their property holdings in light of recent legislative changes and the changing market conditions.

Stamp Duty Changes
The thoroughbred NSW property sector has been further handicapped as NSW is now the only state in Australia to apply stamp duty taxes to property investors on the sale and acquisition of investment properties. The 2.25% vendor tax applicable on sale is due to commence in July of 2004 and will apply retrospectively to any property regardless of when it was acquired.
There are a number of exemptions including:-

• Principal residence
• Farms
• First sale by builders of new dwellings
• Transfer due to divorce or inheritance
• Where the sale price does not exceed the purchase price by 12%
  

Stamp duty on property purchases has also been adjusted with a new rate of 7% applying to property values above $3 million. The Premium Property Tax applying to properties with a land value exceeding $1.97 million has been abolished. First home buyers are relieved of a stamp duty burden on properties acquired up to a value of $500,000 on contracts entered into after 3 April 2004.

Land Tax Changes
In addition the land tax threshold on investment properties has been removed. Land tax will now apply to all investment properties from 31 December 2004. Previously where the land component of an investment property was below $317,000 no land tax was payable. Now it applies at a rate of 0.4% p.a. on land valued up to $400,000. Between $400,000 and $500,000 the rate jumps to 0.6% p.a. and thereafter at 1.4% p.a.

Interest Rates
Market sentiment has already been affected by two Reserve Bank interest rate rises over the last six months. There is expectation of further rises in Australia and overseas as world and Australian economic growth picks up.

Rental Yields
The long residential property market boom has resulted in rising property prices but the downside is that rental income has not kept pace. Rental income on residential properties has fallen from averages of 5% p.a. in the past to 2.5% p.a. now. The net return for many investors after rates and other holding costs is below 2% p.a. and this doesn’t take into account the additional cost of interest.
For others tenants are harder to find and retain. There are often periods without tenants further reducing the total return.

Growth Prospects
Clearly the last ten years has delivered spectacular gains to residential property investors, particularly in Sydney. However, in the last six months the market has softened with auction clearance rates falling. Some sectors such as the CBD apartment market have shown some spectacular falls with many investors trying to exit an oversupplied market and unable to find tenants.

It would be unreasonable to expect the residential property market to continue to deliver the gains it has in the past, over the next few years. Markets move in cycles and it is widely expected that the market will be flat for some years to come. Many analysts predict further falls ahead.

Rethink and Reweight
Investors should always be mindful of the need to have a balanced and diversified portfolio. Share markets have delivered spectacular returns over the last nine months as the investment cycle turns in favour of the share sector both locally and globally. Following protracted falls in share markets globally over the previous three years we regard this sector as the area most likely to deliver growth in the medium term. Diversification of a portfolio into property, shares and other asset classes is important. We reiterate previous comments urging clients to assess their portfolio asset allocations.

As always stock and fund selection is important as is the need for advice. We are here to help.

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