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By Jimmy B Prince, author of Tax for Australians for Dummies

There are two ways to build wealth and more particularly a share portfolio. You can either wait until you’re saved a sufficient amount or you can borrow. If you decide to adopt the save and wait option, there’s a risk you could miss the boat if the share market were to rise in the meantime. Borrowing on the other hand gives you the opportunity to enter the market now and profit in a potentially rising market.

Using the Australian the tax system

Under Australian income tax law, interest payable on capital to buy shares in companies that ordinarily pay dividends is a tax deductible expense. This means before you select a particular company it’s prudent that you check the company’s dividend history policy. Under company law the declaration of a dividend is at the discretion of the company directors. So it’s important that you check whether there’s a ‘reasonable expectation’ that they’ll declare and pay a dividend. When you do this exercise, you’ll generally find all the major Australian companies listed on the ASX (for instance S&P ASX 50) will ordinarily pay an interim and final dividend each year. As a general rule, this shouldn’t be a major concern, if you confine your share purchases to these leading Australian companies. It only becomes an issue if you decide to buy shares in speculative and/or junior mining companies that had never declared a dividend. Under these circumstances, the non-deductible interest is added to the share’s cost base and can be taken into account when calculating a capital gain.

Under tax law if your total tax deductible expenditure (predominantly interest) were to exceed your dividend payments, the net loss you incur can be deducted from other assessable income you derive such as salary and wages, business profits and investment income. This is commonly referred to as negative gearing. When this happens you’ll be able to reduce the amount of tax you’re liable to pay on the other income you derived! Negative gearing is extremely beneficial if you’re paying a 30 per cent or higher marginal rate of tax. This will occur once your taxable income is above $35,000.

To tap into this potential benefit it’s essential that you have another source of income to deduct the net loss. Otherwise, the benefit that flows from negative gearing will be lost. This could arise if your taxable income falls below $16,000, as no tax is payable on this amount. As you’re effectively losing money when you negative gear; the shares you buy must increase in value. Otherwise, you’ll be funding the purchase of an asset that’s generating a negative cash outflow (which defeats the general concept of wealth creation).

How negative gearing works

The following case study illustrates how negative gearing works

Masato borrowed $100,000 @ 8 per cent to invest in the share market. At the end of the financial year, he calculated he paid $8,000 interest on the loan, and received $3,000 dividends fully franked. The franking credits amounted to $1,285. Under tax law Masato will need to include both the dividend and franking credit as part of his assessable income. Masato’s income from salary and wages was $70,000 and his marginal rate of tax is 30 per cent. The tax benefit Masato stands to gain from negative gearing is calculated as follows.

Share portfolio

Interest                                        $8,000
Less
Dividends             $3,000
Franking credit      $1,285              $4,285
Net loss                                        $3,715

As Masato incurred a $3,715 net loss from his investment activities, he can deduct the loss from the $70,000 salary he derived as set out below:

Salary and wages                           $70,000
Less
Net loss on dividends                      $3,715
Taxable income                              $66,285

Tax payable (2009-10 tax rates)      $13,735
Less
Franking credit                               $1,285
Net tax payable                              $12,450

If Masato did not negative gear, the amount of tax he would have paid on his $70,000 salary is $14,850. Because Masato incurred a $3,715 net loss from negative gearing his share portfolio he will save paying tax on the $70,000 salary he derived.

Masato’s share portfolio will need to increase in value to recoup the negative cash outflow he incurred from negative gearing.

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