Wealth Intelligence

Set and forget (wealth strategies) at your own risk

Gearing strategies funded by margin loans have changed over recent years. To ensure ongoing tax efficiencies and effective risk management it is critical that they be reviewed.  And there may be better alternatives.

The current combination of low interest rates, high (franked) dividend yields and, in some cases, lower loan-to-value ratios, means margin loan share portfolios may hold greater risk, be positively geared and no longer be tax effective in a high taxed entity.

What is a margin loan?

A margin loan is a loan used to purchase listed shares, managed funds and some derivatives where the investment is used as security for the loan.

A borrowing limit is set by the lender, based on a percentage of the investment value, represented as a loan-to-value ratio (LVR) [1].

The main risk of a margin loan is a margin call. If the investment falls in price and the LVR exceeds the borrowing limit, then the loan may be at risk of the investor needing to contribute funds into the portfolio or reduce the loan, otherwise the investments may be sold by the lender to reduce the loan.

Pre GFC: margin loans attractive for high taxed entities

Just prior to the GFC interest rates were higher, dividends lower (as a percentage of share values) and in some cases, a higher LVR was available.

As such, it generally made sense to hold the loan and investment in the name of a high taxed individual, as the annual net loss (dividends less interest costs) was deductible against the investor’s other income (despite capital gains being subject to tax at 23.25% [2] ).

Post GFC: changed conditions

Since the GFC, some lenders have reduced borrowing limits and LVRs for some small companies, dividends have increased and interest costs are at historical lows.

This means that if you invest in a diversified share portfolio (with large and small cap shares) worth $100,000 funds available from a margin loan may be limited to between $55,000 and $60,000.

If you choose to maximise the available loan, the risk of a margin call is high and annual net income (dividends less interest costs) is now likely to be taxable to the investor, in addition to realised capital gains.

Margin loans then and now

 

Pre-GFC

Now

Interest rates

Higher

Lower

Dividends

Lower

Higher

LVR

Higher

Lower*

Margin call risk

Lower

Higher**

Tax benefits

Higher

Lower

* for portfolios with some small cap shares.
** subject to loan value and LVR.

A better alternative

It may be timely to review which entity should hold the investments (and loan) and how the loan funds are sourced. An alternative to a margin loan is a loan secured against real (direct) property, which is generally subject to a lower interest rate and has no margin call risk.

However, if the investor defaults on the loan then the property used as security is at risk.

By refinancing a margin loan using a secured (property) loan, it may be possible to move some of the share investments (in excess of the loan value) into a lower tax entity (such as a self managed superannuation fund (‘SMSF’) or family trust), subject to capital gains tax implications, given the removal of the LVR.

For example, Beth is a medical specialist and pays tax at 46.5% on personal earnings. She has a margin loan of $500,000 (current interest rate of 7.8%) with a LVR of 58% and a diversified share portfolio valued at $1 million.

By re-financing the margin loan with a new loan secured against her investment property (with an interest rate of 6%) she is able to transfer $400,000 shares into her SMSF [3] as non-concessional (after tax) contributions, thereby (1) reducing future tax applicable to share income and gains (i.e. dividends and capital gains in the SMSF will be subject to a maximum tax rate of 15%); (2) reducing the loan interest cost; and (3) removing the risk of a margin call.

We note the above information is not personal advice and using a loan for investment purposes should not be undertaken lightly.

While borrowing to invest in growth assets increases the potential for long term gains it also magnifies potential losses. Maintaining a strong cash flow position and being able to hold the investment over the long term is usually vital.

Please contact us to review your wealth management strategies.

[1] LVR is assessed on a share by share basis however is expressed as an average of the total portfolio.

[2] Assumes the shares were held for >12 months and the investor is subject to a tax rate of 46.5%.

[3] Transferring listed shares into a SMSF will only be available prior to 30 June 2013.
IMPORTANT NOTICE:  Any advice contained in this document is of a general nature only and has been prepared without taking into account your personal objectives, financial situation or needs.
Because of that, before acting on any advice in this document, you should consider whether the advice is appropriate for you having regard to your personal objectives, financial situation and needs.