Storm clouds linger over negative gearing

There is still a lingering perception among Australian investors that negative gearing has magical curing powers for their taxation ills. A combination of a culture of investment in residential property as well as the high interest rate environment of the 1980s has left a legacy of blind belief that gearing equals tax relief. But according to industry analysts, the gap between perception and reality continues to widen by the year.

In fact some, such as consultant Paul Resnik, believe you would

There is still a lingering perception among Australian investors that negative gearing has magical curing powers for their taxation ills. A combination of a culture of investment in residential property as well as the high interest rate environment of the 1980s has left a legacy of blind belief that gearing equals tax relief. But according to industry analysts, the gap between perception and reality continues to widen by the year.

In fact some, such as consultant Paul Resnik, believe you would be hard pushed to find a gearing strategy which would provide any tax benefit whatsoever.

Resnik believes that even if you borrow the majority of the investment, the amount of interest paid would only be at best slightly higher than the yield of leveraged investment. Most product providers are currently charging less than 8 per cent in interest charges. The situation gets worse for those gearing into some managed funds which often crystallise capital gains tax positions through the turnover of stocks in a portfolio.

"As far as tax purposes, gearing is irrelevant. The smarter method for investors is to place investments in the name of their non-working spouse," Resnik says.

Resnik labels tax strategies such as paying interest in advance as "smoke and mirrors", arguing the tax benefits available in one year are then absent from the following year. Other tax strategies, such as the use of protected loans, are under a cloud (see story below).

In fairness to margin lending product providers, there is very little promo-tional literature which suggests tax advantages are anything but secondary to the primary aim of creating greater exposure to the market.

As Deutsche Funds Management director Sarah Brennan points out, the average gearing ratio for clients is decreasing across most product providers.

"Margin loans don't have to be risky," she says. "In fact, many of our high net worth clients, who are not averse to investment in equities, are positive gear-ing to leverage the investment."

In the end, it is not the product providers with the responsibility to ensure clients are entering into margin loans for the right reasons. However, the peo-ple charged with that responsibility, financial advisers, often fall well short of the mark, according to Resnik.

Resnik and respected planner Ian Heraud told the recent CFP conference in Sydney that advisers are failing to adequately account for the risk profile of the cli-ent before recommending gearing to clients.

According to figures supplied by Proquest, only about 7 per cent of the popula-tion have a risk profile suitable for leveraged investments.

"Few investors are comfortable investing all their funds in equities," Resnik says. "However, only those investors whose psychological predisposition for more risk than 100 per cent equities should be gearing into equities. Anybody recom-mending margin lending without taking into account the risk profile of the cli-ent is playing with fire."

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BREAK-OUT

While tax benefits continue to fade into the background for investors borrowing to invest, a dark cloud hangs over the Australian Tax Office's attitude to a loan which currently provides a significant tax benefit for investors.

Protected loans, for one, are potentially on the endangered list for loans which currently allow for a tax deduction on interest payments. Australian Taxation Office (ATO) commissioner Michael Carmody has made several references to pro-tected loans over the past 18 months which is making product providers and fi-nancial planners nervous.

While the ATO has made no formal statement on protected loans, those in tax cir-cles are aware the commissioner often refers to a scheme several times before the ATO makes a judgement on its eligibility for tax deductions. Carmody first referred to protected loans in his famous Magic Pudding speech and then again a few months ago on the nine network's Sunday program.

Product providers such as Deutsche Funds Management are warning clients and planners to treat protected loans with care.

"We are not telling advisers you can't use protected loans, but we are warning that the government is taking a look at them. If the government does decide to act on protected loans, it could implement the legislation from the start of the new financial year, immediately or maybe even retrospectively. We just don't know," says DFM director Sarah Brennan.

The reason the ATO is interested in protected loans is the reason most investors find them attractive - the remove some downside risk as well as provide a high interest rate for an increased tax deduction. Protected loans can carry interest rates as high as 30 per cent, but most charge about 18 per cent interest.

According to DFM, the ATO have suggested that a significant part of the interest charged pays for the investment protection rather than the cost of borrowing. Tax deduction can only be claimed on the cost of borrowing, therefore the ATO could argue that a large chunk of the interest payment is not deductible. There-fore, protected loans could be as tax-effective as other forms of negative gear-ing which as the story above outlines is fairly limited.

If the ATO does act to curb the amount of deduction able to be claimed, most product providers feel protected loans are "dead in the water", as one provider put it.

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