A common misconception with negative gearing is that it can only be used for property. False. Negative gearing can be used for any asset where some or all the purchase price is borrowed. Borrowing to invest is called ‘gearing’, and the more you borrow then the more you will pay in interest. If you are making a profit from the investment then you are positively geared. If you are making a loss then you are negatively geared. Regardless of whether you are positive or negatively geared, it is still costing you money. This article explores negative gearing and shares.
ASIC’s MoneySmart website summarises negative gearing well –
If you borrow money to invest in shares your investment will be negatively geared if the dividends from the shares are less than the interest on the loan.
You may be prepared to accept a loss if you expect to be able to offset your losses with a capital gain in the future when the value of the investment increases. An investment loss will reduce your taxable income which will reduce the amount of tax you pay.
Keep in mind that if you are making a loss your investment is costing you money. You will need another source of income to fund the extra expenses.
The loss from a negatively geared asset can usually be offset against other income for tax purposes. This tax benefit – eg. less tax being paid – in a sense adds to the investment return on the asset. However, whilst there are tax benefits accessible through negative gearing, it is also necessary to consider the loss in after tax income.
As a wealth creation strategy, negative gearing only makes sense if the eventual capital gain is expected to be greater than the losses incurred whilst holding the asset. It’s important to remember that on the sale of an asset capital gains are usually taxable, although there is often a 50% discount which can be had.
Negative gearing and shares – the following example shows you one way that negative gearing can be applied in the share market.
Samantha owns a hairdressing salon which earns her about $100,000 a year after expenses. Her marginal tax rate is 37%. Samantha owns one home, valued at $600,000. She has a debt of $200,000 on this home, meaning she has $400,000 in equity. Here are how her assets look:
Samantha decides to make some share market investments. We discuss the benefits of dollar cost averaging into an index fund. (We won’t go into the details of that here). Samantha decides that she will establish a line of credit loan against her home to the value of $200,000. She will use this to make a series of monthly purchases of units in an index-tracking Exchange Traded Fund (ETF). At the end of two years, she has purchased $200,000 worth of units (including brokerage). Her net assets now look like this:
|Units in ETF:||$200,000|
Her preferred ETF pays a distribution that is equal to 4% per year. This equates to $8,000 per year on the holding. The interest rate is 6%. This equates to $12,000 in interest payable. Samantha therefore makes a ‘loss’ of $4,000.
Samantha’s marginal tax rate is 37%. This means that her income tax reduces by $1,480 as a result of the $4,000 loss (37% of $4,000 is $1,480). The after-tax loss on the investment is now $2,520. This is 1.26% of the amount she has borrowed – meaning that if her investment rises by more than this, the capital gain will more than offset the short-term loss. However, the capital gain is taxable, at a discounted rate if Samantha holds the investment for more than 12 months. For Samantha to make a profit after capital gains tax, the gain needs to be 1.55% per year.
This is lower than the current inflation rate, meaning that Samantha will make a profit if her investment (which has been bought over an extended period) keeps track with inflation.