Borrowing to invest?

[Value Hunter]

Just saw this old thread. I think the OP misunderstood a few crucial points:
1) Just as the value of your assets are impacted by inflation so to will the real value of your debts shrink over time due to inflation.
2) Interest costs are tax deductible against the dividends
3) franking credits which in some instances can be used to offset income taxes from other sources.

Let use as an example of a hypothetical company who over a 10 year period gives a return which is in line with long-term market averages of around 10 or 11% per annum (nominal/gross). Let us assume that the tax payer is on the 32.5% marginal tax bracket (for incomes between $37,001 and $90,000). The below example assumes income is spent rather than reinvested.

Lets say you buy shares in ABC corporation at $10 per share. You buy 1000 shares ($10,000). You use $6500 of your own money and borrow $3500 on a margin loan. You pay 5.8% interest on your margin loan (a readily available current market rate for a one year fixed margin loan). We assume interest rates (and margin loan rates) remain the same over the ten year period.

Over a 10 year period you get annually 4% fully franked dividends plus 6% capital growth. Let us assume that dividends increase due to earnings growth at the same rate as share price growth of 6% per annum. Note: all figures are rounded down to the nearest dollar.

So here is what the cashflow situation will look like when geared:

Year 1: dividends received: $400. Franking Credits received: $171. Interest paid: $203.
Therefore cash flow situation is: $400 dividend - $203 interest = $197. 32% Tax payable on $197 is $63.
$197 in net dividends - $63 tax plus $171 franking credits = net cashflow $305.

Year 2: dividends received: $424. Franking Credits received:$181. Interest paid: $203. Tax payable on $221 is $70.
$424 - $203 interest = $221 - $70 = $151 + $181 (franking credits) = $332 net cash flow.

Year 3: net cashflow = ($449 + $193) - ($203 + $78)= $361 net cash flow.
Year 4: net cash flow = ($476 + $204) - ($203 + $87) = $390 net cash flow.
Year 5 net cash flow = ($504 + $216) - ($203 + $96) = $421 net cash flow.
Year 6 net cash flow= ($535 + $229) - ($203 + 106) = $455 net cash flow.
year 7 net cash flow= ($567 + $243) - ($203 + $116) = $491 net cash flow.
Year 8 net cash flow= ($601 + $257) - (203 + $127) = $528 net cashlow.
Year 9 net cash flow= ($637 + $273) - ($203 + $138)= $569 net cash flow.
Year 10 net cash flow= ($675 + $290) - ($203 + $151) = $611 net cash flow.

Initial investment: $10,000. $10,000 compounded at 6% per annum for 10 years = $17908 - $3500 margin loan = $14,408 in equity (compared to starting equity of $6500)

Scenario 2 is you buy $6500 worth of shares without borrowing any money:
Year 1 net cash flow= $260 dividend + $111 franking credits - $83 tax = $288 net cash flow.
Year 2 = $275 dividend + $118 franking credits - $88 tax = $305 net cash flow.

So you can see compared to the first example of buying shares on margin produces more cash flow than buying shares un-geared (when interest rates are low). Also capital growth in the example is higher when gearing is used. Ending equity after 10 years when gearing is used is $14,408. Without gearing starting equity is also $6500 but ending equity is only $11,640.

In the example I have given the total return over a ten year period (equity growth plus cash flow) will be more than 50% (on the initial $6500 investment) higher using the geared strategy.

Of course my example is simplified and real life is a bit more complicated than that but its a good overall illustration of the general principle. So basically to summarize when interest rates are low as they currently are it is very easy to enhance both cash flow and capital gains using leverage. Obviously the strategy generally does not work when interest rates are high.

 

[Zaxon]

2) Interest costs are tax deductible against the dividends

While loan interest payments are certainly deductible against dividends (income), if you borrow to invest in shares which pay no dividends, how is the loan interest expensed?

I think it works this way:

1. Interest is deductible against any investment which you expect to make income, or capital gains. So borrowing to buy shares which pay no dividends is still a taxable deductible investment.
2. On your tax return, your income from dividends is $0
3. At D7 (interest deductions), enter your loan interest costs (so far that puts you into a loss state)
4. Capital losses are subtracted from capital gains (including discounts etc), and the final taxable capital gain is entered into your tax return
5. Once your capital gain hits your tax return, it effectively becomes "income" you're taxed on.
6. The interest deduction from D7 is now subtracted from your capital gain, this reducing your taxable income

Is that your understanding on how loans are expensed with there's no dividend income?

 

[tech/a]

And of course if you happen to have a negative capital growth your bottom line suffers accordingly and is magnified on margin.

Personally I prefer to park cash in bricks and mortar.
My choice is commercial / Industrial. Particularly as
A defence for the currently non existent or marginal
Ravages of inflation.

 

[willy1111]

While loan interest payments are certainly deductible against dividends (income), if you borrow to invest in shares which pay no dividends, how is the loan interest expensed?

I think it works this way:

1. Interest is deductible against any investment which you expect to make income, or capital gains. So borrowing to buy shares which pay no dividends is still a taxable deductible investment.
2. On your tax return, your income from dividends is $0
3. At D7 (interest deductions), enter your loan interest costs (so far that puts you into a loss state)
4. Capital losses are subtracted from capital gains (including discounts etc), and the final taxable capital gain is entered into your tax return
5. Once your capital gain hits your tax return, it effectively becomes "income" you're taxed on.
6. The interest deduction from D7 is now subtracted from your capital gain, this reducing your taxable income

Is that your understanding on how loans are expensed with there's no dividend income?

My understanding is that if there is no reasonable expectation of receiving dividends, any interest incurred would not be deductible but would rather be added into the cost base when doing the CGT calc, known as a third element of the cost base. See ato link https://www.ato.gov.au/General/Capi...ments-of-the-cost-base-and-reduced-cost-base/

Example, you paid $10,000 for a parcel of shares that produce no dividends, over 5 years you incur interest of $2,500 as you borrowed the $10k, and you receive $20,000 when you sell after 5 yrs..

Capital proceeds of $20k, less $12.5k cost base (includes interest) = cap gain of $7,500, 50% CGT discount of $3,750 applied and thus $3,750 is taxed at marginal rate.

Just my understanding.

 

[Zaxon]

My understanding is that if there is no reasonable expectation of receiving dividends, any interest incurred would not be deductible but would rather be added into the cost base when doing the CGT calc

Interesting. Well, there will be will the expectation of dividends (although I didn't state that in my post). If you're investing in growth stocks (as opposed to targeting yield stocks) to flesh out my question, it's quite possible the dividends won't cover the interest payments, even though divs exist. A portion of the loan interest will be funded out of capital gains. Capital gains ends up as being a part of your total assessable 'income', and I'm hoping, can have expenses deducted against it.

 

[Value Hunter]

I think its a little bit of a grey area. Because the ATO talks about reasonable expectations of producing income? How do you define reasonable expectations of paying a dividend and over what time frame?

You might buy an ASX listed company that is loss making today but is growing its revenue rapidly and has forecast that it will be profitable within the next 18 months. After the company is profitable it will likely start paying dividends. Or what about a company that historically paid dividends in most years but cut its dividend in the current year because it had a bad year but can be expected to resume dividends within the next few years? To me these are cases where it could be argued there is a reasonable expectation of a dividend.
However for example a junior biotech or junior mining exploration company which are both still 10 years away from producing revenue might be a different story.
Therefore even if a company is not currently paying a dividend in some cases you could still arguably use the interest costs to offset your other income.


Also just as with other assets like property even if the company pays a very small dividend and you have large interest costs the full amount of the losses can be used to offset other income. If the stock pays a $100 dividend and you pay $1000 interest on the loan you can still use the whole $900 loss to offset other income. This is not a grey area at all and is very clear (to my knowledge at least).

 

[willy1111]

I think its a little bit of a grey area. Because the ATO talks about reasonable expectations of producing income? How do you define reasonable expectations of paying a dividend and over what time frame?

You might buy an ASX listed company that is loss making today but is growing its revenue rapidly and has forecast that it will be profitable within the next 18 months. After the company is profitable it will likely start paying dividends. Or what about a company that historically paid dividends in most years but cut its dividend in the current year because it had a bad year but can be expected to resume dividends within the next few years? To me these are cases where it could be argued there is a reasonable expectation of a dividend.
However for example a junior biotech or junior mining exploration company which are both still 10 years away from producing revenue might be a different story.
Therefore even if a company is not currently paying a dividend in some cases you could still arguably use the interest costs to offset your other income.


Also just as with other assets like property even if the company pays a very small dividend and you have large interest costs the full amount of the losses can be used to offset other income. If the stock pays a $100 dividend and you pay $1000 interest on the loan you can still use the whole $900 loss to offset other income. This is not a grey area at all and is very clear (to my knowledge at least).

My thoughts exactly...well put.