(03) 9020 2905PORTFOLIO POINT: New rules require new thought processes. Perhaps it’s time you considered gearing strategies as a way of beating legislative changes, battered portfolios and a listless investment horizon.
The Rudd Government has been successful with its super contributions spin campaign. The halving of the limits, so their wrong’un goes, will only affect a wealthy minority or those on “obscene” incomes.
Many Eureka Report readers know that to be rubbish. Yes, it will impact on the wealthy. And, yes, it will hit those on very high incomes. But there are likely to be tens of thousands of Australians, who aren’t rich or on high incomes whose retirements and futures are going to be considerably poorer as a result of these changes.
While we can hope that a government of the future will reverse the changes and introduce limits that are less restrictive, we can’t expect it to happen. Even if it does, it might not happen in time for those planning their imminent retirements.
Retirement planning – taking in both superannuation and non-superannuation monies – will necessarily become more complicated again. The main messages: start earlier and use different strategies. For those who would have taken advantage of the previous limits of up to $50,000 (for the under 50s) or $100,000 (for the over 50s, for the next three full financial years), new plans will be required.
The problem: non-concessional contributions just aren’t the same
Post-Budget number crunching by investment house MLC used the following example: Michael is a 47-year-old earning $100,000 a year wanted to contribute $55,000 into his super fund in the 2009-10 financial year. That would have included $9000 from his employer and $46,000 as salary sacrifice. Following the Budget, he will only be able to contribute $16,000 in salary sacrifice, while $9000 would still come from his employer’s SG contributions. Using conservative growth and income assumptions, MLC worked out that if he were to put in $19,800 (the equivalent after tax sum of the $30,000 extra he had intended to contribute), then his super would be approximately $100,000 worse off after ten years.
This is for a person on the second top marginal tax rate (which will be 39.5%, including the Medicare levy, from July 1 this year), but would be putting in some money that had been taxed at the middle marginal tax rate of 31.5%. It’s hardly an obscene income. For those whose salaries are higher, or on the top marginal tax rate of 46.5% (including the Medicare levy), the shortfall would obviously be even bigger.
Other strategic solutions
So, how do you make up for the smaller super balance? There are many ways to skin this cat. All of them, however, will involve an investor/member taking on more risk, or making a larger sacrifice of income or capital (such as putting more after-tax, non-concessional, contributions into your fund).
Yu could increase your exposure to growth assets (shares and property), if you have a significant enough time horizon, of a minimum of five or seven years. The inherent risk in this sort of strategy is that there is another correction or no recovery. Although, the experts believe, the chance of the market collapsing a further 50% from here is slight.
Another option is gearing, either inside or outside of super. Gearing nowadays applies to both super and non-super alike. And the rules are similar for both property and shares.
Gearing and risk magnification
A general warning: Gearing is not suitable for everyone. Gearing through the share market downturn from November 2007 through to March 2009 would have destroyed wealth much faster than a no-gearing strategy
Gearing allows investors to control a larger asset, or more assets, than they would otherwise be able to hold. If someone had $100,000, they are unlikely to be able to afford to buy an investment property. However, if they went to a bank and borrowed, say, another $300,000, they would be able to afford a reasonable property.
If the value of an asset class increases by 20%, then a $100,000 asset will increase in price to $120,000 (a $20,000 gain), while a $400,000 asset will increase in price to $480,000 (an $80,000 gain). Similarly a 10% fall in a $100,000 asset would see it fall in value by $10,000 to $90,000, while a 10% fall in the $400,000 asset would be a $40,000 fall to $360,000.
That’s gearing in a nutshell. But what about negative gearing?
Broadly, Australian tax law allows an investor to reduce his/her income by the ongoing costs of an investment, including interest, if the costs outweigh the income. If the rent from a property is $20,000, but the interest bill is $30,000, then the property could be said to be negatively geared to the tune of $10,000. If an investor was on a $100,000 income, then the investor would only have to pay tax on $90,000. At current tax rates, this would reduce the tax our investor above would have to pay by $3950 (for the 2009-10 financial year).
Negative gearing means losing money. If you lose $10,000 a year on an investment, how can you be making money? It will only make sense if the investment is rising in value by substantially more than $10,000. If you’re losing $10,000 but the property has increased in value by $30,000, then you’re still ahead.
Adding a gearing strategy
Gearing strategies might be something that investors want to consider to help make up for this latest meddling in super by the government.
Let’s take the fictitious investor outlined by MLC that we discussed above.
The investor can no longer put in the $30,000 extra into super through salary sacrificing. The option discussed above, where he put in the $19,800 that was left of the $30,000 after tax would have left him with $100,000 worse off after 10 years.
Let’s assume the following facts. The same investor has some equity in his home. He has $200,000 left on a home loan on a property worth $700,000.
He finds a suitable investment property, which costs $400,000. It will rent for $340 a week ($17,000 for the year, assuming two weeks’ vacancy).
The outgoings include agent’s fees ($1400 a year), insurance ($1000 a year), rates ($800 a year) and a general allowance for emergencies/upkeep ($2000 a year). From a tax efficiency perspective, he borrows the entire sum, plus the cost of stamp duty, so his loan is going to be $420,000. Because of his combined loans, he sources finance at 5.2%. The loan is interest only, so costs him $21,840 a year. Total costs are $24,340 a year. (But please note that current interest rates are historically low and is unlikely to reflect a long-term average
This property is negatively geared to the tune of $10,040 a year (ignoring depreciation).
Our investor would be able to claim this against his income. The net cost would fall to $6074 a year (assuming a marginal tax rate of 39.5%). If that asset were to increase in value by a compound rate of 5% a year, the property would be worth nearly $652,000 after 10 years. Over that period, rents would rise, which would also reduce the ongoing cost of the negatively geared property.
The risks of this strategy include:
- Property prices fall, which would magnify the investor’s losses.
- Interest rates rise significantly, making the property more expensive to hold and increasing the hurdle at which property would have to perform.
The investor will also have to pay capital gains tax if the investment is ever sold.
Purchasing property in super
Purchasing property in super is similar to purchasing it outside of super. But there are several key differences.
Firstly, it doesn’t matter how much equity you have outside super, lenders will not lend 100% or more of the value of a property to a super fund. This is a function of the law, which requires non-recourse loans within super. Banks, therefore, must ensure the super fund has some equity in the investment.
New bank loan products are being released all the time, but typically, a bank will lend around 70% of the value of a property to a self-managed super fund. In our example, this would mean a loan of $280,000. The investor would therefore have to have $140,000 ($120,000 in equity, plus $20,000 for legal costs and stamp duty).
The rent is still $17,000 a year and the rest of the fixed costs are the same. Interest rates are likely to be a bit higher (we’ll assume 6.2%), so the interest bill on $280,000 will be $17,360.
This produces a property that is negatively geared to $5560 a year. The super fund’s tax rate of 15% will mean this falls to a net cost of $4726 a year. (Again, interest rates are probably below the long-term average, so this should be built into assumptions for your own circumstances.)
The real potential advantage here is that if the property is sold after the super fund is flicked into pension phase, there will be no capital gains tax to be paid on the property’s gains.
It’s not just property
While this article has discussed negative gearing for property, the rules apply equally to share-based investing, both inside super and outside.
Banks are coming to the party with products for property investment, but things have been considerably slower in the arena of share-based investments. Lift Capital, which slumped into administration about 14 months ago, was an early failure. The old-style self-funding instalment warrants disintegrated late last year. And several other providers have put super-gearing strategies for shares on the backburner for the time being at least.
Gearing strategies have the potential to help investors rebuild super and non-super portfolios shattered by events of the last 18 months, plus the ongoing threats posed by governments. But gearing strategies involve higher risk, so don’t go in blindly.
Please note:
My broad views on the direction of residential property prices have barely changed since I wrote this piece in March (http://www.eurekareport.com.au/iis/iis.nsf/pages/AC8B2F11194E78E4CA25757600130DB3?OpenDocument). Since then, the Government has confirmed the extension of the first home owner’s bonus, which will only delay the bottom third of the market taking its medicine – if anything, prices have stayed level or even risen slightly. The middle and upper thirds of the market are taking their medicine and have fallen and we have seen further evidence of that in many cities since then.
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Note: The strategies mentioned above are general advice and are not intended to be acted on without having your personal financial situation taken into account. If you believe that these strategies might be of some value to you, then please contact your adviser for more information
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Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking. He is also the author of The Power of Property (Wrightbooks, 2006) and Investing in Real Estate For Dummies (John Wiley & Sons, 2008)