The whole point of an investment is to make money.
Tax cleverness and debt structures can be useful tools but it is critical that you know the implications of these. Equally they should never be the reason why someone goes into investing in the first place.
Tax and debt must always be paid and it is important to understand the full consequences of utilising these tools. Without full understanding, investment strategies could be a lot more vulnerable than they seem.
Negative gearing – you carry twice the risk
David is a typical example of someone who did not fully appreciate the debt risks he was carrying. In his early 50s, he thought his family finances were doing well:
- An income of $430,000 per annum
- An investment property held in Frankston Victoria for 10 years, negatively geared
- Small mortgage on the family home in Brighton Victoria
- 6 year tenure at an ASX listed company with a large quantity of share options.
Then he experienced an unexpected redundancy in a round of M&A activity and his income stopped.
- The investment property was valued at $450,000 – the same price as when it was first bought
- Due to some poor (self-interested) advice from a mortgage broker a debt recycling strategy meant that the investment property carried a total debt of $560,000.
He had excess debts and when his income stopped he was unable to service the debt. Negative gearing is not only borrowing against the asset but is also borrowing against future income to sustain the costs of holding that asset. It carries twice the risk.
Negative gearing can be a useful starting point but the end point of investments is to move to positive gearing – so that the asset pays for itself and starts to generate an income for you.
The debt recycling strategy simply shifted the mortgage debt from the family home to the investment property.
David was forced to sell the investment property at a time not of his choosing and the net effect was to further increase the family’s debts. The investment strategy did not make any money and in fact created losses – not least of all the opportunity cost of 10 years of lost financial prospects.
Share options carry tax liabilities – and that is still a debt
This was exacerbated by the tax liability on the share options.
Share options are a common way to reward senior executives: a reward for the success of the business. What is often overlooked is the tax implications when they vest – and this is tax owing at their original value. Irrespective of whether they have gone up or down in value. In the latter case it is feasible that the tax liability may be higher than the value of the shares.
David faced a six figure tax bill on the vested share options, which he had not accounted for. His redundancy pay-out was largely taken up by the tax liability thus putting pressure on living expenses for the 14 months it took him to secure a new job.
It is hard to move on in life or have choices when you are trying to repair your finances. It can take years to recover financially.
Debt is a commonly used financial tool – it’s how you utilise it that is the important thing.
I have never forgotten a saying I once heard: “Everyone who has made a lot of money uses debt. Everyone who has gone bankrupt uses debt.”
A useful analogy is the wood chopping competition at the Sydney Royal Easter Show – these burly men sharpen their axe to the point they could shave the hairs off their forearm with it, yet they wear a pair of $40 Dunlop Volley canvas shoes. These shoes allow flexibility and grip on the log but no protection. It is a trade-off. To trust the accuracy of their swing, that they will not chop off their foot. The axe is a dangerous thing … how you use it is the important thing.
Some considerations to guide you
- Pay attention to the cost of servicing your debt compared to your income. The corporate equivalent is the interest coverage ratio.
- Understand the type of debts you have:
- Negative gearing carries twice the risk.
- Debt recycling from your home to an investment structure is simply shifting the debt – it still needs to be paid.
- Have a concerted debt reduction plan.
- Understand share options and the tax implications of when and how they vest.
- Plan ahead and have sufficient flexibility so that you can adjust to changes in circumstances.
- Understand that the point of investments is to create an income.
To maximise your financial position and the opportunities you need all three financial tools – tax effectiveness, debt structuring and investment strategies – working together in one coherent plan.
* Whilst the case study is based upon real life people and their financial situations, names and other details have been changed.