High Gear - Revving Up Your Investments

Gearing is simply borrowing to invest, and if well executed it can accelerate wealth creation.

The investment can be funded through a margin loan or you can use existing equity such as a home equity loan to raise the funds required. However the strategy is not without risk and does not suit everyone.

Gearing is a strategy that has been gaining in popularity. Some of the features and pros and cons are set out below:

Positive Gearing

This arises when the net income from the investment is greater than the interest charge and other costs of the strategy. A very popular strategy is to gear into dividend paying stocks. Because of the benefits of franking, the dividend yield required to break even is less than the interest rate.

Negative Gearing

A very common example is a rental property financed with borrowed funds where the interest payments and other associated costs exceed the rental return. Note that this strategy will result in a loss unless the combination of income and capital growth eventually overtake the after tax costs of borrowing.

Some of the Benefits of Negative Gearing are:

• If successful, wealth can be accumulated faster than with non geared investments.
• The investor is entitled to a tax deduction for their expenses of up to 48.5%.
• There is no capital gains tax liability until the investment is sold. Thus a taxpayer can reduce their tax liability by selling the investment in a year their income is low.
• If the investment has been held for at least 12 months then 50% of the gain is exempt from tax. For an individual taxpayer the maximum tax paid is then 24.25%.

The Downside of Negative Gearing

Since expenses exceed income the shortfall has to be funded. Leverage works in both directions, gearing is equally effective in magnifying losses. A much smaller move in the value of the investment will result in 100% loss of equity compared to an ungeared investment. When using a margin lending facility there may be margin calls if the value of the investment falls. There are possible risk management costs such as income protection. Investment markets do not go up in a straight line, there is a possibility that you might gear into your investment before a market decline. Therefore having a long term outlook is especially important as early exit could realize large losses.

Margin Lending

Installment gearing, i.e. leveraging a set percentage of your target amount each month is the lowest risk, and probably the most sensible strategy for most investors. It also has the added benefit of allowing you to dollar cost average into your investment.

At a 50% gearing ratio it would normally require a 38% fall in the value of your investment before you were likely to receive a margin call.

Ownership of the Geared Investment

The choice of ownership of the investment can make a substantial difference to the after tax returns where the possible owners are in different marginal tax brackets. The general rule is:

Positively Geared - it is almost certainly better to be in the name of the person in the lower tax bracket. Also assets that are initially negatively geared but soon become positively geared should also be held by the investor in the lower tax bracket. Negatively Geared - generally in the name of the person in the higher tax bracket as they would be able to claim the largest tax deduction.

Who should use gearing

Gearing is an aggressive strategy and may not be appropriate for all investors. People who are considering gearing should:

• Ensure their goals are not attainable without gearing.
• Have a high risk tolerance and be able sit out any volatility.
• Be able to commit to a 5 to 7 year program.
• Have a reasonably high and stable income.
• Willing to take out risk insurance, particularly income protection.
• Leverage within their means and have sufficient liquidity to meet potential margin calls, generally at leastone-third equity is recommended.
• Gearing should not be done purely for tax reasons, the asset that is leveraged should be considered a sound investment.

While not endorsing gearing for all investors, it can be an effective wealth creation tool for some investors when it is correctly implemented. To find out if you fit the risk profile or if you would like more information simply follow this link: Enquiries and mention "Gearing".

Source: Personal Wealth

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