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Any new investment involves considerable risk that asset prices may fall instead of continuing to rise. The more risky the investment, the greater the risk of borrowing to fund the transaction becomes.
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To make a profit out of negative gearing, at least one of two outcomes is required. First, the asset needs to increase in value and be likely to continue to hold that value. Second, annual investment income needs to rise over time and ultimately cover all related expenses including borrowing costs.
A common misconception is that with the tax system chipping in to help fund ongoing losses the annual yield from an investment is not crucial to choosing investments. The reality is, however, that apart from periods of rampant inflation, a steady or fast rise in annual investment income is needed to increase the possibility of future capital gains.
A steadily rising income stream from an investment also helps protect against the risk of interest rates suddenly rising, unless this possibility is covered by fixed interest rate borrowing. Provided the investor has surplus taxable cash flow to be able to service ongoing investment losses, loan servicing costs aren't a major consideration for higher marginal tax rate borrowers.
With three-year fixed rate loans now available at about 4 per cent annual interest, the after-tax costs for investment borrowers range from 2 per cent to 3 per cent depending on annual income. A more important consideration is the stability and growth prospects of the investment income stream and the ability to fund any ongoing losses.
The tax system provides a major incentive not to pay off investment loans at least until any other owner-occupied housing and credit card debt has been paid off – hence the popularity of interest-only heavily geared investment loans.
By paying off owner-occupied home and consumer debt first, investors achieve a far higher return from their savings. Unlike many other countries, Australia provides larger tax benefits to investors than to owner occupiers. Our tax rules provide no benefit to home owners with mortgages and require these borrowers to service their debt out of their income.
Even with interest rates as low as 4 per cent, the effective cost for owner occupiers with the standard 35 per cent tax rate is 6 per cent because of the income tax payable on the money used to service the mortgage. Therefore the clever strategy for all investment gearing is to reduce all outstanding personal debts before paying down any investment loan.
Daryl Dixon is the executive chairman of Dixon Advisory
