Golden Rules for Tax Efficient Investing

Fairfax has been running a series of articles (see here and here) on the collapse of Great Southern and the hardships it has caused, a timely reminder of the perils of mixing debt, investment and tax breaks. Almost every case consists of investors borrowing to invest on the advice of a “trusted professional”, large amounts were amounts borrowed and the investments were generally done in search of a tax break. When the investment went bad, the investors were left with huge debts that they are still struggling to pay off. From Fairfax:

“They know my loan was doctored and I didn’t meet the loan criteria, but still they pursue me,” he says.

Great Southern’s plunge into administration and infamy laid bare toxic conflicts within the accounting and financial advice professions, led to a series of explosive parliamentary hearings and, eventually, added to momentum for the royal commission now underway.

The commission has shone a spotlight on aggressive, unethical and potentially illegal behaviour by financial institutions in Australia but will not consider Great Southern.

For thousands of burned Great Southern investors like Gilham the past decade has been marked by financial devastation as Bendigo, the country’s fifth largest retail bank, determinedly pursues them over hundreds of millions of dollars in loans taken out to invest in the ill-fated forestry giant.

A Fairfax Media investigation has examined the stories of dozens of such investors, who say they were misinformed about the risks of investing in Great Southern by financial advisors who incorrectly told them the loans were non-recourse, which means if debt was called in, Great Southern was on the hook, not the investors.

It’s a timely reminder for anyone with property in a self-managed super fund.

My prediction is that we are 2-3 years away from replaying the same stories but remove Great Southern and add properties in self-managed super funds that were bought from spruikers at free seminars (often at inflated prices) and leveraged as much as possible.

I know I can’t stop you chasing tax breaks, but hopefully these rules will help to ensure that you don’t end up as another statistic:

Rule 1: Choose your investment first without regard for tax

Forget about tax, work out whether the investment is a good one or a bad one before you even think about tax. If you can’t justify an investment without incorporating some sort of tax benefit then you probably shouldn’t be investing.

You might like an investment on pretax returns and then reject it after considering the post-tax returns – but you should never do the opposite.

Rule 2: Get your structure right

It is sensible to invest using a tax-efficient structure – but you need to consider not only the financial cost but the time cost and the potential for additional liabilities/responsibilities.

Choosing between investing in your own name, a company, a trust or a self managed super fund is sensible.  But, if you need to create a special structure to save yourself a few dollars in tax then consider:

  1. How much will you pay in accountancy/legal fees? I’m not saying don’t listen to your accountant, but you should do the numbers yourself. If the structure results in a $3,000 tax saving but a $2,500 accountancy bill, then your accountant will probably think it’s a good idea. You need to work out if the $500 extra will be worth the extra time you have to spend and the potential liabilities.
  2. How much extra work every year will you need to do? If you hate doing one tax return then why are you signing up to add company or self-managed super tax returns to your annual list of chores?
  3. If the tax rules change how much will you be out of pocket? For example, spending $5,000 upfront on a fancy structure to save $2,000 per year might leave you considerably out of pocket if the rules change.
  4. Are you might be taking on additional liabilities and responsibilities? For example, becoming a director has additional legal ramifications. Your structure might affect how you will be treated legally if things go badly.

Rule 3. Debt is Dangerous

Debt can make a good asset great. But, debt can never make a bad asset good, and it can make an average asset bad.

What I mean is if your investment loses money, then there is no way that having debt will make the situation any better. An asset that only returned say 2% might be disappointing if you invested in it without debt, but the investment is not disastrous. An asset that returned 2% funded by debt while you are paying 10% interest rates might be disastrous.

I am very wary of using debt to invest in anything volatile. Never use debt to get yourself a tax break. If you are taking out a margin loan then make sure you can meet the margin calls if the stock market falls.

A common example might be borrowing against an investment asset (usually tax deductible) and using that money to say reduce your home loan (not tax deductible). First, this is playing with fire from a tax perspective (it may fall foul of Part IVa of the tax code), second check the interest rates, in many cases higher interest rates mean that the benefit is negligible. And definitely don’t increase the amount you invest to access a bigger tax break. Often the equation is:

  • investment goes well, save a few hundred dollars or so in tax
  • investment goes badly, financial ruin
  • plus potential to fall on the wrong side of the ATO

Rule 4. Never invest in an asset where the sales pitch has a major focus on tax breaks

Go back to rule number one.

Rule 5. Try not to let tax affect your decision about when to sell

There are timing benefits in when you might take a capital gain or a capital loss.

But, I’m much more comfortable selling an asset earlier than I might have preferred to take advantage of a tax situation than I am holding onto a poor investment, hoping that it doesn’t fall further while I wait for some tax advantage.

That is, don’t hold onto a poor investment that might get worse just because you are hoping there will be a tax benefit.

Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

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Damien Klassen

Damien has a wealth of experience across international equities (Schroders), asset allocation (Wilson HTM) and he helped create one of Australia’s largest independent research firms, Aegis Equities. He lectured for over a decade at the Securities Institute, Finsia and Kaplan and spent many of those years as the external Chair for the subject of Industrial Equity Analysis.
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Comments

  1. “A common example might be borrowing against an investment asset (usually tax deductible) and using that money to say reduce your home loan (not tax deductible). First, this is playing with fire from a tax perspective (it may fall foul of Part IVa of the tax code),”

    It’s not even a Part IVA issue, it is basic deductibility issue. Deductibility depends on the purpose of the what you do with the funds raised, not the asset that you have secured the borrowing against. So if you borrow against your BHP shares and use the money to pay down your mortgage, you don’t get a deduction. And that’s before you get into rate differentials.

    • True, but you sell your shares, pay your loan down with the proceeds, then borrow to buy shares, and it’s all good.
      Or use savings to pay down mortgage, and borrow to buy shares, or some other arrangement that isn’t technically borrowing against shares to pay home loan, but amounts to virtually the same thing.

  2. One other thing to think about is time value of money. Things like negative gearing (ignoring CGT discount) or Agri investing are little more than timing advantages (get a deduction now, pay tax on income later). Those might look a bit more attractive when rates are high but in the current environment they have relatively little value.

    • Forrest GumpMEMBER

      Rule 5. Try not to let tax affect your decision about when to sell
      In my unqualified limited and simple opinion: Depends on circumstances. Its best to do the math first.
      You may be holding an asset with some capital gain and want to cash in your chips (e.g. sell a long term asset like a block of land or house). It may be worth considering waiting for a financial year when your taxable income is in a lower bracket so that you have better bang for your buck with regards to capital gains tax.

      Just plug the numbers into a spreadsheet and do 10 minutes of research first to see what the outcome will be prior to pulling the trigger.

      Just get the tax scales from the ATO website, plug it into a spreadsheet and then plug in your income, expenses, holding costs and capital gains (Only 50% of the capital gain is taxable). Then run the numbers.

      Same story with negative gearing. Its best to run the numbers through a spreadsheet first and model the outcome. Use best case and worst case scenario’s based on your projected taxable income and tax payable. (Negative gearing only works if you pay tax in the first instance and intend-or have the capacity to continually pay tax (Read- earn generous income that is highly taxed)

      I sometimes do this for work colleges that are negative gearing to show them actually how much they are really “gaining” for all their pain and suffering. Most a shocked to find out that negative gearing is not all that glamorous.

  3. Golden Rules for Tax Efficient Investing? Keep it simple.

    Invest in forever stocks, collect fully franked dividends along the way, sell them CGT free after you are 65 yo if you want to.

    • How do I find these “forever” stocks? Would KODAK have been one in the 80’s? FAIRFAX media?
      Is facebook one now? Google? What about myspace and yahoo.

      • Well since 2016, which is as far back as i can go without looking too hard:)
        Westfield limited, QBE and Transurban limited have fallen out of the list.
        How many more have in the last 30 years? Doesn’t really seem like a forever list to me.

      • Well they may not be in the ASX 20 forever (corporate actions etc) but they are generally companies that have been around forever.

      • CSL, COH, WOW, ASX

        Internationally any of the following will qualify:
        Nestle, L’Oreal, 3M, Philip Morris, Berkshire Hathaway, Mastercard, Visa, Coca cola,
        Intercontinental Exchange, etc.

      • Phillip Morris is a brave call. Do they do anything other than tobacco?
        Sounds like a great candidate for the KODAK moment.

      • Of course, there are risks in each of them. Philip Morris is in the same category as Coca Cola – a clear market leader in an industry sector that is facing headwind. But can the entire sector be wiped out? I hardly think so, from the way people are having hard time quite smoking. The same for Coca Cola.

        I will add REH for the local list. Maybe IVC? But none of them are trading below the fair value right now.

  4. Let them eat equities…. or a equities for my kingdom…. pilgrims pay labour tokens to the magic dispenser of holy water [financial markets] after being enthralled by the magic temple doors that open by themselves [forced participation in criminal extraction or your pension gets it] ….

    Like old Robbin Williams said and I quote…. grab the back of the T.V. and feel the power of T.V. ….

  5. mikef179MEMBER

    I work in an office with some accountants and I hear one of them all the time virtually telling his clients to invest in something (usually property) because it has good tax breaks. I just shake my head…

    Another rule, don’t get investment advice from your accountant. And if one tries to give it unsolicited, dump them.

      • mikef179MEMBER

        Pretty much. I think he might plausible deniability through not talking about specific properties. Maybe. Not really sure how exactly the law works in that regard….

    • When I got my most recent tax return done, my accountant advised me that I was paying off my two units (that I finished building at around late 2013/ early 2014) too quickly and that I was getting minimum benefit from negative gearing.
      I have also done the whole deprecation rigmarole. I’m renting out both units (with no rent increase since the tenants moved in, partly because they don’t seem to be wrecking the place(s) ) and also contributing around 40% of my pay.
      The aim is to have it all paid off within 5 years or so.

      • But if you do that, then it’s a good chance you’ll be able to ride out a downturn and you won’t get to blame everyone else when your finances go sour. Where’s the fun in that?

      • The fun will be when I can hopefully retire at 60, collect my super. Give my employer a long-overdue middle finger and happily do my own thing while not answering to a “wife”. LOL

    • Debt is not a monolith, in fact debt is the historical foundation to money it self, it precedes tokens as a psychological anchor point to trade e.g. without it trade in the modern sense could not even exist. You would all be bartering like tourists in some 3rd world country.

      • mikef179MEMBER

        What I mean is, Australians don’t understand leverage. Sure, they understand how it can improve profits on the way up, but very few understand the downside consequences.

      • Ok so now were taking about risk and uncertainty w/ a side of what constitutes or drives issuance in relationship with wage earnings or sales driven income and T&S, not expectations of feed back loops wrt financial driven income to facilitate the contract, am I right.

        Just to elaborate a bit… which is more of a concern, indavidual debt issued by creditors or corporate debt issued by the shadow sector and risked by derivitives and VaR. What are the total comparisons and how that might reflect on market functions.

      • Exactly mikef179… when someone leads with debt is dangerous without any means to evaluate the statement and then when we start getting in to the weeds about whose debt and how the sausage is made and what constitutes a significant threat to the payment system and commerce at large… but yeah… average mopes just don’t understand endemic risk….

      • He doesn’t say debt is bad. He says it’s dangerous.

        He’s right. It’s like fire. Bloody useful. Essential to civilisation. Also dangerous if you don’t understand it and it gets out of control.

  6. goldren rule #1: invest in a diversified ETF and walk away until retirement… free up some labour in the finance industry.