Negative gearing — when you borrow money to acquire a rental property and claim the interest against your rental income — is a well-known tactic within the rental property market. But did you know that it also works for other forms of investments, such as shares?
If you’ve got an appetite for risk, you can claim a tax deduction for money borrowed to finance a share portfolio — a so-called 'margin' loan.
The reason for the deduction is that there is an expectation that the shares will derive assessable income, in the form of dividends or capital gains, and therefore there is a 'nexus' to the interest that makes it tax deductible.
If you borrow money and some of it is used to finance share purchases but some of it is used privately (for example, to buy a car or pay for a holiday), you can only claim the interest incurred on the part of the loan used to acquire the shares. This will mean that you have to apportion the interest, which can be tricky!
The shares may well produce a taxable income stream in the form of dividends, but the interest deductions on the loan will hopefully go a long way to offset this.
In addition, costs incurred on borrowing expenses (such as establishment fees for the loan, legal expenses and stamp duty) are deductible.
If borrowing expenses are more than $100, the cost must be apportioned over five years or over the term of the loan, whichever is shorter. Borrowing expenses under $100 are fully deductible in the year incurred.
Even if the shares don’t pay dividends in a particular year, it is still possible to claim the interest on the borrowings, so long as there is a reasonable expectation that the shares will generate assessable income over time.
In addition, if the shares increase in value, any capital gains that you make on disposing of the shares will attract the 50% CGT discount (if you hold the shares for at least 12 months). They may also attract a lower tax rate anyway if you sell them when you are on a reduced income — for example, in the lead-up to retirement.
This isn’t a strategy for the faint-hearted; it’s very easy to find your losses multiplying in a falling market, with a loan to repay but a greatly diminished investment portfolio from which to repay it. You need to aim for a return on the shares that is greater than the cost of the interest rate you are paying.
One way around this is to use a capital-protected borrowing strategy. This typically involves an arrangement under which you use a limited recourse loan to fund the acquisition of shares, meaning that the borrower is wholly or partly protected against a fall in the market value of the investments.
Because you need to be relatively experienced to manage the strategy, this isn’t recommended if you are new to investing. Always talk to both a financial adviser and a tax adviser, like H&R Block (NYSE:HRB), before implementing this sort of planning.
Mark Chapman is the director of tax communications at H&R Block. As well as operating his own private practice, Mark spent seven years as a Senior Director with the Australian Taxation Office. Mark is a Chartered Accountant, CPA and Chartered Tax Adviser and holds a Masters of Tax Law from the University of New South Wales.