Consumer debt is debt incurred on consumer products and services.
Consumer debt is usually very expensive – some credit card debts charge up to 20% per annum – and is not tax deductible because it does not relate to assessable income.
We once met a GP with a credit card debt of more than $250,000. The interest bill was about $50,000 a year, and the GP had to earn nearly an extra $100,000 a year just to pay the interest: 20% non-deductible is the equivalent of nearly 38% deductible. That’s extremely expensive money and it’s impossible to get ahead with that sort of a millstone around your neck. Particularly if it means you have to work seven days a week every week just to make ends meet.
Happily most GPs know consumer debt is expensive and avoid it wherever possible. Encounters like this are very rare. Our GP ended up consolidating the loan on to his home loan, and effectively reducing the interest rate to a much more manageable 5% per annum. This was not hard to arrange: GPs are excellent credit risks, it’s due to the height, stability and longevity of their incomes, and a new bank was more than happy to do the deal.
Home loan debt
Home loan debt is debt incurred on buying, maintaining or improving a home.
Home loan debt is usually not that expensive, since the loan will be secured by mortgage over the home, and this means there is little risk for the lender. Rates are currently about 5%.
Home loan debt is not tax deductible: it is not incurred for the purpose of producing assessable income and it is inherently private and domestic in nature. This means a GP has to earn nearly $2.00 for every $1.00 of home loan interest, and 5% non-deductible is the equivalent of nearly 9.5% deductible. That’s still expensive money, and although not impossible, it’s hard to get ahead with that sort of a millstone around your neck.
GPs should pay off home loans as fast as possible. Paying off a 5% home loan is the same as earning about 9.5% capital guaranteed, adjusted for tax. That’s the best investment a GP will ever make (except for owning a practice).
Are there faster ways to pay off a home loan? Sometimes there are. For example, a GP setting up a new practice with $100,000 cash in the bank may choose to pay the $100,000 off the home loan and borrow to pay for the new practice. Get advice if not sure how these strategies work.
Interest offset accounts
Interest offset accounts are recommended for all GPs with home loans. Don’t pay off the home loan, and don’t put the money on deposit either: pay on to the interest offset account instead. There are two advantages:
- the GP does not get taxed on interest income, and instead pays less non-deductible interest (equivalent to 9.5% per annum); and
- the GP can withdraw their equity from the offset account when up-grading the home, and retain the old home as a geared residential property investment
Investment debt is different to consumer debt. Properly managed investment debt improves the GP’s overall economic returns and helps build long term wealth.
Economic theory predicts in the long run interest rates will be less than the average returns on properties and shares. If this not the case in the short run borrowers will stop borrowing. This reduced demand will lower interest rates. Eventually interest rates will fall below the average returns on properties and shares, plus a premium for risk, and borrowing will recommence.
Borrowers will only borrow if they expect average returns on properties and shares to be greater than the interest rate.
Economic history shows the theory to be correct. The ASX Report for 2013 says Australian property earned an average of 9.5% per annum and Australian shares earned an average of 9.8% per annum over the two decades to December 2012.
This means most GPs who borrowed to buy representative properties and shares over the last two decades increased their wealth by doing so. This is because the assets earned more than 9% per annum, but only cost about 7% per annum. This is what we have seen with our clients over this time too. Examples abound, and include:
- the GP who borrowed big to buy a Brighton surgery in 2000 for $550,000, who geared it up again in 2006 to extend it for $500,000, and who in 2014 owns a debt free $2,000,000 CGT free asset producing about $120,000 in rent a year; and
- the GP who started buying index funds in 2007, just before the GFC, and continued buying while the market was falling, and while the market was recovering, and now has a simple, low cost, commission free, investment portfolio worth more than $1,000,000 on top of his super and
Positive gearing is where the income from a geared asset is greater than the interest.
For example, in December 2012 ASX Investor Update newsletter Paul Zwi from Clime Investment Management observed that National Australia Bank shares offered a high dividend rate of 7.5% or 10.7% grossed up for franking credits.
GPs who borrowed to buy NAB shares would have experienced positive gearing, income greater than the interest cost. The shares would have paid for themselves, and a bit more, even before capital gains were considered.
Positive gearing reduces risk and by improving cash flow it improves the GP’s ability to reduce debt or make fresh investments or both.
Common sense is needed: the critical question is will the expected income in fact be derived? Do your due diligence, but to be frank if you stick with blue chip investments like NAB shares it’s hard to see what can go wrong.
We have seen structured positive gearing products blow up in GP’s faces. In 2007 one well- known institution marketed a positive gearing arrangement where GPs borrowed from one arm of the institution at 9% per annum, to invest in another arm of the institution at a “guaranteed” 12% per annum. What could go wrong? Well, what went wrong was in the fine print all the time. The guarantee was not a very good guarantee and was in fact discretionary. Not surprisingly, after about 6 months the institution invoked its discretion and stopped the 12% income payments to GPs, but enforced the 9% interest charge on GPs.
From the institution’s point of view the fine print was very fine: there was nothing the GPs could do but pay up and wait for five years to get their money back, less interest.
The institution made a fortune from it.
Negative gearing occurs where the income from a geared asset is less than the interest cost, creating a loss. GPs can usually offset this loss against other income for tax purposes. This creates a tax benefit, in the form of less tax being paid than otherwise, and this tax benefit in a sense adds to the investment return on the asset.
Negative gearing does not make economic sense, however, unless the GP expects to earn a capital gain greater than the loss, so that overall the GP is better off from making the investment.
This capital gain is not taxed unless the asset is sold, and even then usually only half the gain is taxed, provided the asset was owned for more than 12 months.
How does negative gearing work?
A simple example shows how negative gearing works. Let’s assume a GP buys $100,000 of property using alternatively no gearing, 40% gearing and 80% gearing, and after one year the property increase in value by $10,000. The position is as follows:
|Equity invested Amount borrowed Amount invested Gain % Increase|
Gearing leverages the investment to increase gains when asset values rise.
But there is a reverse gear too. Gearing leverages the investment to increase losses when asset values fall. Let’s assume our GP stays in the market with her $110,000 of geared property using alternatively no gearing, 40% gearing and 80% gearing, and in the second year the property falls in value by $20,000. The position is as follows:
|Equity Invested||Amount to be borrowed||Amount Invested||Gain||% Increase|
The tax benefit of $1,800 is a cash benefit, and is the equivalent of $3,272 in pre-tax income, representing an extra 3.3% net return on the investment. Over time rents will rise and depreciation will expire, and the tax loss will become a taxable income.
Our GP knew she would incur this tax loss in the early years, but was prepared to cop it because she expected taxable income in the later years and because she expected the property to increase in value over time. Her time profile is decades, not years.
Has negative gearing worked for GPs?
Historically negative gearing has worked well for GPs. Most GPs who borrowed to invest did well, over time. Gearing has worked best with quality well located residential property, surgery premises and blue chip shares. Australian shares index funds are particularly suited to gearing compared to individual shares, because they have relatively lower risk.
The ASX Report for 2013 says that Australian property returned 9.5% and Australian shares returned 9.7% in the two decades to December 2012. Interest rates averaged less than 7%, which means most GPs who negatively geared property or shares over the last two decades improved their net wealth.
It’s likely that over the next two decades most GPs who negatively gear property or shares will improve their wealth.
It’s not about the tax
It’s critical to see negative gearing as an investment strategy with a tax flavour, rather than a tax strategy with an investment flavour. GPs should never negatively gear an investment just to get a tax benefit. Negative gearing only makes sense where the GP genuinely and reasonably expects the after tax capital gain on ultimate sale, plus a premium for risk, to be significantly greater than accumulated tax losses on holding the asset, adjusted for the time value of money.
What sort of investments should be geared?
Most well located metropolitan residential properties, blue chip shares and index funds are suited to long term gearing strategies. They have stable and predictable income streams and are relatively low risk. It’s safe to say they will stand the test of time and still be there, generating income and holding their value, two decades from now.
What about apartments?
In 2014 we are seeing heavy marketing of apartments, particularly pitched at GP’s SMSFs. Tax benefits feature in the glossy spreads. Yes, there will be tax benefits, but these will not compensate for the poor or even non-existent capital gains on these investments.
All the tax planning in the world cannot make a bad investment into a good investment, and GPs should only borrow to buy good investments. We expect that two decades down the track apartments will not feature in any “great investment” stories.
And apartments definitely should not be geared.
Risks of gearing
We generally encourage GPs to negatively gear investments, particularly blue chip shares and properties. Provided common sense is used, and a very long-term view taken, these investments will probably do very well. But there are some risks. The Australian Financial Planning Handbook 2012-13 (Thomson Reuters) identifies 6 main gearing risks. These are:
- the risk that the investment’s value will fall;
- the risk that interest rates will rise, causing net returns to fall;
- the risk of a margin call, or some other form of equity contribution being needed to preserve the lender’s required debt to equity ratio;
- timing risk, ie the risk that income may lag behind interest payments causing stress;
- occupancy risk, ie the risk that a suitable tenant cannot be found or that a tenant will damage the property (only applies to geared property investments); and
- other risks, such as losing income due to unemployment or
The nature of a GP’s income, ie its height, stability, scalability and longevity, and borrowing ability, mean that these risks should be of less concern than for others. The GP can assume these risks, comfortable that they can ride out any rough patches, and that in two decades time blue chip shares and properties will still be there and will have increased in value.
But obviously common sense is needed.
Guarantees and GPs
Noel Whittaker, in his book “Golden Rules of Wealth” (Simon and Schuster 2011) dedicates chapter 32 to a vigorous argument for never guaranteeing someone else’s loan.
We agree that GPs should not guarantee someone else’s loan if they are not related to that someone else. What’s the point of doing that? It’s all risk and no return. If the borrower defaults the bank will look to the guarantor first, since the guarantor normally has the deepest pockets.
Yes, the guarantor can recover from the borrower under the doctrine of subrogation, but its complex, may involve legal action and what happens if the borrower just can’t pay?
It’s a good idea for GPs to have a policy of not guaranteeing someone else’s loan. For example, if you are asked to guarantee another GP’s loan for the surgery premises, don’t. Don’t be intimidated into it: if the other GP says they will lose money if you do not give a guarantee it is almost certain you will lose.
Guarantees for a GP’s spouse/life partner are a different matter. Both partners are an economic entity and the bank will see them as in effect one client. If say the husband wants to borrow say $500,000 to buy $500,000 of shares, and offers the family home, value $1,000,000, as security, then realistically the bank will want a spousal guarantee particularly if the home is co-owned by both spouses.
This is fair enough. Both spouses benefit if the shares increase in value, and both spouses should secure the loan. The bank is not being unreasonable. Of course occasionally one partner may not agree gearing shares is a good idea. Here the unhappy partner should refuse to sign the guarantee. Obviously both spouses need to agree with a big decision like this.
Guarantees for a GP’s children are a different matter too. We frequently suggest GPs volunteer to guarantee loans to adult children as a fast track to entering the property market years earlier than otherwise would be the case. In early 2014 the Melbourne median home price was more than $600,000 and the Sydney median home price was more than $650,000. That’s a lot of loan. How can an average income 30-year single person buy a home without parental support? Take care, and make sure your child is buying sensibly, and it’s almost certain the strategy will pay off.
Limited guarantees are a great idea here. The bank limits the guarantee to say 30% of the amount borrowed. This 30% guarantee takes the place of owner’s equity, and means the bank has met its normal debt to equity ratio of say 70:30, and is adequately secured.
Guarantees for a GP’s companies and trusts are a different matter too. Sometimes the company or trust will have plenty of assets and there will be no need for a related party guarantee. For example, a company with $2,000,000 of property will be able to borrow $1,000,000 to buy another property without a related party guarantee.
It’s unrealistic to think a bank will lend money to a company or a trust without significant assets unless the directors and related persons guarantee the loan.
Some general thoughts on borrowing
Your bank manager is not your friend
Your bank manager is your opponent. His income is your cost. He sits on the other side of the table and is interested in you paying as much as possible for the money you borrow.
You can be friendly but do not be friends.
Look for the cheapest loan possible
The interest reduces the net return on the investment. The higher the interest rate, the lower the net return. So it makes sense to minimize the interest paid on a loan.
Ensure interest is tax deductible
The first way to do this is to make sure the interest is tax deductible, in the sense of being connected to assessable income. Most GPs pay a reasonably high rate of tax and claiming interest as a tax deduction reduces the amount of tax paid. When debt is used to buy or hold an investment the interest is deductible.
GPs should separate their loans so they are not used for a mix of private and investment purposes. It is better if the borrowings are in different loans. Quarantine them. Don’t mix them up. This makes it clear the debt was used for investment purposes, and helps make sure the interest is tax deductible.
Minimise the interest rate
Make sure you do not pay too high an interest rate. Some banks try to charge higher rates than necessary. The person you are talking to is usually on commission (and that includes many bank managers), the incentive for a lender to help the borrower get the lowest rate possible may not always be high. Your accountant should be able to help here.
Sometimes a GP will take a loan in the name of the trustee of his or her family trust, or perhaps the trustee of his practice trust. This trustee is usually a company, with the letters ‘pty ltd’ after the name. Some lenders will assume that the loan is a business loan and try to apply a higher interest rate. Don’t agree to this. Banks will lend at home loan rates to a company or trust if the underlying security is a residential property.
In summary, if the security is residential property the home loan interest rate should apply.
The home as security for a Loan
Any asset can be used to secure a loan. It does not have to be the asset bought with the loan. For example, a GP may mortgage their home to buy index fund units. The interest will be deductible because the purpose of the loan is to earn assessable income. The interest rate will be low because the home is the best security for a loan.
This is the cheapest way to finance an investment, and one we routinely recommend to GPs.
Sometimes GPs worry about using the home as security for a loan. They are concerned the home may be lost if the borrower defaults. This should not really be an issue. The issue is the net wealth of the borrower. Net wealth is the difference between what the borrower owns and what the borrower owes. If a borrower owes $100,000 on a $500,000 property, for example, and there are no other assets, then the net wealth is $400,000.
Provided the overall net wealth exceeds the value of the home, the home will not need to be sold. The other assets can be sold to pay off the liabilities. Consider an example:
A GP owns a home worth $500,000 and has $100,000 cash saved. This means that she has $600,000 in net wealth. The GP borrows $240,000 against her home and uses it to buy index funds (using dollar cost averaging, of course). She now has $840,000 in assets and $240,000 in debt – her net wealth is still $600,000. If something happens and she needs to repay the loan she can sell the index funds. She will not have to sell the home.
In summary, the advantage of lower interest rates, which means higher net returns and less risk, justifies using the home as security for a loan.
Margin loans are loans secured against the security of a share or similar security, such as units in a managed fund.
The GP can borrow up to an agreed % limit, say 50% or 70% of the value of the securities. If the value of the securities falls the GP faces a “margin call” and has to pay additional capital in, usually within 24 hours, or the lender will sell the securities to repay the loan.
Margin loans were popular with GPs up to the GFC. But harsh margin calls and high interest rates between 2008 and 2011 caused a lot of pain.
Memories linger and in 2014 margin loans are not popular with GPs.
Line of credit loan
A line of credit loan is a flexible loan with an upper limit. The borrower may draw as much or as little as they choose. Interest is only charged on the amount of money actually drawn (subject to a minimum amount).
The borrower can repay some or all of the line of credit at any time.
Lines of credit provide simple access to debt finance and are generally recommended to GPs, even if not needed right away: it’s comforting to know finance is there quickly if needed.
GPs who borrowed money to gear sound investments in the past two decades or so have mostly done very well. Many wish they had geared more investments. Those GPs who lost money tended to sell too quickly. They did not fully appreciate that property and shares investments are long term (at least two decades,) and a year or two of poor performance does not mean they should be sold.
Other GPs just made poor investment decisions, but they tend to be in the minority. Diversification is the key, reducing the prospects of being left with just one or two poor performing assets.
It is hard to accumulate significant wealth without taking on at least some debt for some time. The amount of debt is a personal choice, and reflects an underlying view of, and attitude towards, risk.
GPs who take on debt to invest will probably end up wealthier than those who do not. But there are no guarantees.
Borrowing to invest
If you need more convincing that GPs should be borrowing more, get a copy of Borrowing to Invest: The Fast Way to Wealth. A User’s Guide for Borrowers, by Noel Whittaker and Paul Resnik (Simon & Schuster, 2002). No-one can accuse the authors of not being conservative, and they are elder statesmen in the financial advising community.
Their opening paragraph reads:
“Are you prepared to use other people’s money to build a better life for yourself. Have you stopped to think about what will happen if you don’t? Chances are you would never own your own home. Every mortgage is, after all, built on someone else’s money. And, unless you are heir to a fortune, it’s just as likely that your years in retirement will be years of watching the dollars.”
In Personal Finance for Dummies financial journalist Barbara Drury explores similar thoughts:
“Many people still feel uncomfortable about borrowing money to invest, a practice referred to as gearing. Yet the same people cheerfully borrow to the gills to buy their own home because they understand that the only way to own such an expensive asset is to use other people’s money.
“Borrowing to buy growth assets, such as shares or property, and using your own cash or equity in your home as a downpayment, helps you increase your returns. You make a profit as long as the investment returns (income plus capital gains) are greater than your interest payments. Say you have $10,000 and borrow another
$10,000 at 8% interest to buy shares with a dividend yield of 4%. The dividends of
$400 cover your interest payments but you stand to make double the profit when you sell the shares because you bought twice as many shares as you could have done with your own money.
“Gearing can substantially increase long-term investment returns, but it magnifies the potential risks as well as the potential rewards. If you choose to gear into shares or investment property, invest in a diversified portfolio of high-quality assets that have the best chance of producing solid capital growth over the long term. Never gear to invest in speculative investments, or to avoid tax.”
An investment is negatively geared if its income is less than the interest incurred on any amounts borrowed to acquire it. An investment is neutrally geared if the income is roughly equal to the interest on amounts borrowed to acquire it. An investment is positively geared if the income derived is greater than the interest.
The investment may be property (residential, retail, commercial or industrial), shares or similar securities in listed or unlisted companies, or managed funds or indexed funds. Each of the major asset classes is suited to geared investment strategies.
The word geared is chosen because of its engineering connotations. The idea is that with correct gearing or leverage a result can be obtained that is better than that obtained without gearing. This is usually achieved by expanding the asset base and allowing time for capital gains to
accrue, which more than compensate for the deficiency in cash flow caused by the interest being greater than the income.
This technique usually works, but there is no guarantee. It depends on the quality of the underlying investment. Gearing works in reverse too. The effect of any drop in value will be greater, and it is possible equity in an investment will be wiped out as a result.
An economically rational investor will be prepared to negatively gear an investment if the expected after-tax return, including capital gains, is greater than the expected after-tax cost of holding the investment. The after-tax return will usually be made up of the income from the investment (rents, dividends, or distributions, depending on the investment), and the increase in value, or capital gain, over time. Income can usually be predicted with reasonable certainty. Capital gain is the wild-card. No one knows the future, so the best you can do is expect a capital gain. This is where investing becomes an art rather than a science, as expectation will be the critical issue.
The Australian Master Financial Planning Guide, published by CCH Australia, provides a useful example of how gearing engineers a greater return for the investor:
An investor has several options, based on an initial investment amount of $40,000:
- Investing $40,000 as an ungeared
- Investing $80,000 as a geared investment with borrowings of $40,000.
- Investing $120,000 as a geared investment with borrowings of $80,000.
- Income from the investment is 4%.
- Capital growth is 5%.
- Interest on borrowing is 7%.”
The results are as follows:
|Less interest paid||Nil||$2800||$5600|
|Net cash flow||$1600||$400||$800|
|Return on equity invested||9%||11%||13%|
The example shows that the more the investment is geared, the greater is the return on equity invested, assuming capital growth of 5%. GPs should realize the assumed income levels and capital gains amounts are conservative. Long-term earnings rates are actually much higher, at 9%. Most GPs who geared investments over the past two decades got better results than this.
The author also shows “what would happen if the market value goes down by 5% rather than increasing by 5%”. The revised table looks like this:
|Less interest paid||Nil||$2800||$5600|
|Net cash flow||$1600||$400||$800|
|Return on equity invested||(1%)||(9%)||(17%)|
We do not know of any wealthy person who has not taken on some debt for business or investment purposes. We have also never known of a bankrupt person who has not taken on some debt. Debt can increase investment returns and it can reduce investment returns.
Clearly care is needed.
It is best to keep to sensible debt levels, manage interest costs and favour higher income- yielding investments if the down side of debt is to be avoided.
The Australian Master Financial Planning Guide says: “An investor should only make a negatively geared investment if:
- The investor has secure and permanent income from other sources sufficient to cover living expenses as well as the shortfall under the negative
- Where the gearing arrangement or borrowing includes a liability to make margin calls in certain circumstances, the investor can satisfy the margin calls by supplying further security or by payment from other sources to avoid the possibility of a forced sale [keep in mind that the economic conditions that lead to the need for a margin call will, almost certainly, mean that any forced sale will be at depressed prices and will lead to a significant loss to the investor].
- The investment is made on the understanding that it will be retained for at least 5, preferably 10 years or
- The investment and borrowing have sufficient flexibility to cover events such as death, disablement, major illness or redundancy, the first three of these would normally be covered by insurance or superannuation benefits and redundancy could be covered by an employer pay-out. However, even in these circumstances the negative gearing arrangement may need to be terminated. Check whether this can be done without incurring penalties and with the flexibility to avoid suffering loss through a forced sale of the asset.
- There is flexibility to cover changes in circumstances, such as a transfer overseas (where the tax advantages may not apply) or
- The taxpayer can take full advantage of the tax deduction. Negative gearing normally works best for investors on the highest marginal tax rate but may be of less value to low tax-rate or non-tax-paying investors.”
The author warns of the danger of negatively gearing into an already geared investment, such as a listed company or a property trust. This increases both the up-side risk and the down-side risk even further.
Handy hints for getting the money Pay the interest
The ATO does not like allowing deductions for un-paid interest. There is some doubt as to whether this is correct at law, but we believe it’s easier to pay the interest on time than it is to argue with the ATO. So make sure all interest is paid, and not capitalised, if you are claiming a deduction.
Study the contract
Research the costs before you sign the contract. Make sure you know the interest rate, the principal repayment rate, the administration costs and the penalties for early repayment.
Shop around. The first offer is unlikely to be the best offer. Remember that GPs are good risks so make sure you get an offer that reflects this. Look for a bank that offers special deals for GPs. Most do. The banks know that GPs have virtually a nil delinquency rate on debts, and this means more money can be lent at lower rates while still maintaining profitability.
Some brokers specialise in GPs and other health professionals. Their rates are as competitive as the banks and they usually offer better personalised service, and are less stringent on debt to equity ratios and similar prudential issues, making them easier to deal with.
Make sure your application is clear and to the point. Support it with accounts, company searches, business plans and similar documents where necessary. These materials are best included as appendices to the main application as they may cloud the message you are trying to deliver. If the loan is for business or investment purposes, stress this, as it may be relevant if the ATO questions the deductibility of any interest claimed on the loans down the track.
Ensure your finance application shows that all repayments can be met out of your existing and expected business cash flows. If asset sales are contemplated in the short or medium term say so, as this is relevant to your capacity to service the debt. Financiers may not be impressed if the repayment of principal depends solely on the sale of the object investment.
Do not borrow too much. Most banks work on a debt-to-equity ratio of about 70:30. In working out the value of your equity they discount historical cost by factors representing their expected resale experiences. Take account of these discount factors before you commit yourself to a transaction. Ensure your finance application includes all relevant materials, including all financial information that does not favour your application. If something goes wrong later and the bank finds out that you withheld information, problems will arise.
Keep the communication channels open. If something does go wrong, tell the bank immediately. This is important because banks base their recovery actions on their perceptions of how the borrower behaved. If your word is your bond, then you will get much better treatment if an unexpected situation arises. For example, banks will extend an existing facility over the phone without any extra security when CPs ask for it for whatever reason. Because trust has been established, the banks will help out if needed. Open and honest communication is the key to building this sort of a relationship, and once it is created, you shouldn’t waste it.
Banks will be reasonable if you are reasonable, so play with a straight bat at all times.
Offer subject to finance
If you are borrowing to buy property, consider making your offer subject to finance from a specified branch of a specified bank at a specified time, say a month. If something goes wrong you will probably not lose your deposit. If you change your mind within the specified timeframe you may be able to “arrange” for your finance application to be refused so you can get your deposit back. But make sure that the finance condition specifies which bank and even which branch of that bank. If you do not do this the vendor may arrange finance for you through a lender you would not use.
Hints for income tax time
Consider a facility such as a fully drawn advance, or an overdraft, that allows you to pre-pay interest. Pre-paid interest is generally tax-deductible in the year it is pre-paid, provided the pre- payment period does not extend for more than 13 months.
Non-deductible debt, which is not connected to a business or investment activity, is the most expensive debt. Every $1 of interest takes up almost $2 of pre-tax income. A basic tax planning strategy is to pay off expensive non-deductible debt as soon as possible and defer paying off cheap deductible debt as long as possible.
If you have a 15 year home loan of $200,000 and a 15 year investment loan of $200,000 it makes sense to pay off the home loan at twice the usual rate and pay nothing on the investment loan.
Keep your banks apart
Separate your financiers. For example, consider having your home loan with the ANZ, your business loan with the National Australia Bank and your credit card with Westpac, and do not let them have cross-securities. Each bank should have security over just one asset.
This may sound messy, but if something goes wrong it will be a lot harder if not impossible, for each bank to tie up the various securities provided to them.
Choose the right type of finance
Different types of finance suit different borrowing needs. For example:
- A chattel mortgage may be appropriate for plant and equipment costing $60,000 where you are putting up $30,000. This will speed up your GST refund, maximise your depreciation claim and allow you to include your equity in the plant and equipment in other finance
- Operating leases do not have to be shown in your business balance This can help present a good financial position to other financiers.
- An overdraft may be appropriate for funding your practice outgoings in February, as the effect of your four-week January holiday kicks in, or for funding other short-term dips in cash flow or unexpected But overdrafts are expensive and if they look like becoming permanent then you should convert them to a cheaper, long-term type of debt, using homes as security to minimise interest rates.
- An overdraft, being inherently short-term, is not appropriate for acquiring long-term assets such as practice premises, except where the debt proportion is very small and/or is expected to be paid back quickly, say within 12
Let someone do the work for you
Use a consultant who is experienced in dealing with banks and who can represent your interests competently. The consultant should have a good handle on both the accounting and legal aspects of your practice.
Consider using a finance broker. They are constantly in touch with the market. This saves you time dealing with lenders and saves you money because in most cases the broker can get you a better interest rate. Normally using a broker does not cost you anything because the lender pays the broker, not you.
Try to minimise the time you spend on dealing with the banks. Time better spent in your practice. You can’t bill for time spent talking to your bank manager or worrying about talking to your bank manager.
How to manage debt
Debt is a fact of life for most GPs. It may come from starting a practice, buying into a practice, buying a home or acquiring investments. It requires careful management and control so it does not cause financial loss and pain, rather than wealth creation.
Unless you are born with a silver spoon firmly in your mouth, there is normally no choice but to borrow to acquire assets of any significant value. It is hard to save up $300,000 to buy a home. By the time you do, you will probably be looking for a retirement home anyway.
A controlled amount of debt, used intelligently, can have a great influence on the quality of your life and on your net wealth position. It allows you to acquire assets otherwise outside of your reach and to benefit as the value of the assets rises and as the debt is gradually repaid.
However, misuse of debt leads to financial trouble. Be careful. These simple rules will help you deal with debt and avoid being financially hurt:
- Deal only with the major banks, not fringe players. They have their moments, but generally they are keen to get the medical profession’s business and will offer discounts on normal rates. Shop around. GPs are almost always good credit risks, so make sure you are not dealing with the shark end of the market, because you certainly do not have
- Remember, debt has to be repaid from after-tax A loan of $300,000 may not sound like much, but it requires almost $600,000 of pre-tax income to be repaid. This applies to all debts, not just private debts.
- Never borrow without a clear plan for repaying within a specified Debts can be repaid by fresh borrowings, by selling an asset, by cashing out super fund benefits (conditions apply) and by harnessing the practice’s cash flow properly. Sometimes a combination of these methods may be used. Each repayment method has its place.
- Always pay off non-deductible debt first (eg, debt on private credit cards and to buy a home). These are the most expensive loans because the interest is funded out of pre-tax dollars. Avoid them where Borrow so that the interest is tax-deductible.. Get expert advice before settling your strategy.
- Consider consolidating your debts into one facility with one lender. This normally lowers the interest rate. If things are really out of hand, think about extending the loan. This may take the pressure off a bit and let you get back on your
When should negative gearing be used to reduce a tax bill?
The answer is never. Only borrow money to buy an asset if the expected income plus the increase in the asset’s value exceeds the interest and other costs connected to owning the asset. In other words, the expected return must exceed the expected cost of the investment.
This means that the expected before-tax gross income plus the expected before-tax capital gain must be greater than about 11% a year before a rational investor would borrow to buy an income-producing investment. At a rate below 11% you will lose money.
How high you go above 11% depends on your perception of the risk implicit in the investment proposal. As a guide, don’t go under about 15%. Without such a margin it’s just not worth the effort. Your time will be better spent in your practice. If this base condition is not met, it doesn’t matter that the net loss on owning or holding the investment is tax-deductible. A loss is a loss.
You will be better off paying income tax and putting what’s left of your money in the bank.
This doesn’t mean you should never borrow to acquire appreciating assets. This can be a strategy. But if you are going to be better off the basic rules of investing must be satisfied.
Forms of finance
There are several common forms of finance used to fund business and investment activities.
The bank overdraft is a simple concept. It is like a bank account, but instead of you being owed money by the bank, you owe money to the bank. The amount that you owe fluctuates over time as funds pass in and out of the account. Interest is almost always fully tax-deductible even when a private or non-business cheque is written. The revolving nature of the overdraft means the Commissioner of Taxation is not able to trace through the overdraft account to apportion interest between deductible and non-deductible purposes.
Bank overdrafts tend to be at a high rate of interest. At the moment, 8% or more is common. You also have to factor various bank charges into the cost of the finance. These can easily add another 1% or more to the cost of the overdraft.
Overdrafts have the advantage of being flexible so you only pay for the money you use for the time you use it. Normally banks require a first mortgage over real estate to secure amounts lent on overdraft facilities. The better the security, the lower the interest rate.
Why consumer credit is not good for you
Credit cards are typically used to buy consumable goods and services, and these fall in value over time. People using credit cards to buy such goods are usually reducing their net wealth.
Some consumable goods and services are unavoidable. Food, shelter, clothing, and health are all things people need. They are often referred to as non-discretionary consumable items, as the buyer does not really have the discretion to decide whether to buy them.
Some consumable goods and services are avoidable. They are discretionary consumable items, or luxury items, as the buyer does have choice as to whether to buy them.
When the purchase is made on a credit card, and the buyer pays interest, then the price of the purchase becomes even higher. This increases the negative effect on net wealth.
Not all credit card purchases attract interest. Most cards allow an interest-free period. If the user of the card pays the credit card bill in full before interest charges are applied, then they do not pay interest. However, only 30% of credit cards are repaid within the interest-free periods, meaning 70% of credit card users pay interest.
Bank overdrafts are a sensible way of funding most small-to-medium medical practices and are frequently used by GPs.
Term loans are the next most common form of finance. Most practices will have them. Term loans are simply a loan for an agreed period or term. They can be interest-only or principal and interest and they can have a fixed or variable interest rate.
Term loans can be repaid early without penalty if the interest rate is variable. If the interest rate is fixed, the bank loses if the loan is paid out early and this loss is almost always passed on to the customer.
Beware of changing banks just because one is offering an interest rate that is one percentage point below the others. Ask how long this will last and whether the discount continues if the loan is reviewed. The answer is usually no.
Term loans can be used to create flexible debt packages that achieve personalized financial goals. A GP who owes $400,000 on a loan used to buy a property could structure the debt by having $300,000 as fixed interest-only for five years and $100,000 variable interest and principal for five years.
This combination means that the GP can be reasonably certain of the net cost of the finance for five years, as three-quarters of the interest charge is fixed, and ensure a significant amount of debt ($100,000) on the variable interest loan will be paid off within five years. Some principal can be repaid early without penalty. At the end of the fifth year the remaining debt of $300,000 would be refinanced with the same bank or a new bank in line with the market conditions and the GP’s circumstances at the time.
Under a finance lease, the lessee borrows an amount of money equal to the cost of the asset being leased. The lessor owns the asset but the lessee is able to use the asset provided that the lease payments are made on a regular basis and particularly with larger leases, the asset is properly housed maintained and insured.
Finance leases are normally used for plant and equipment, and furniture and fittings purchases, as well as motor vehicles.
The advantage of a finance lease is that all payments made under the lease agreement are tax- deductible, even though part of the payments is a repayment of part of the principal amount borrowed to buy the asset.
The taxation advantages of leases can be overstated. Most items of plant and equipment can now be depreciated over either a three or five-year period. In the case of a four-year lease of computer equipment, the cost of the equipment would have been depreciated over three years anyway, so a lease would be tax-inefficient.
Most lease contracts provide for a residual payment at the end of the lease term. If this residual payment is not made, possession of the leased asset will revert to the lessor. In most cases, the lessee will make residual payments but you should not make a residual payment if for any reason the market value of the leased asset falls below its residual value.
The ATO has released guidelines for the minimum term and residual payments for leases. These guidelines must be satisfied before the ATO will accept that the finance contract is a lease and the lease rentals are deductible losses and outgoings for income tax purposes.
For example, if you buy a computer using lease finance over three years, the Australian Tax Office will only accept that the lease rentals are deductible if the residual value is not less than 30% of the amount of the cost of the computer.
Normally leases do not require any additional security because the leased asset provides sufficient security. However, financiers normally will not enter into lease contracts with companies without directors’ guarantees. Larger contracts or contracts for unusual and hard-to- sell plant and equipment may require collateral security.
The luxury car depreciation rules do not apply to lease contracts. This makes leases particularly attractive for buying cars with a cost of more than about $60,000 (more for environmentally friendly cars such as cars with diesel engines). All lease rentals, including those connected to the cost above the luxury car limit, will be deductible.
Commercial hire purchase
Commercial hire purchase contracts are similar to lease contracts. They are typically used to buy plant and equipment, and furniture and fittings, including cars.
The big difference is that the borrower borrows money to buy the asset and is the owner from day one. This means the borrower is able to depreciate the asset for income tax purposes. The payments made under the hire purchase contract are a mix of principal and interest, and the amount of deductible interest will calculated using the ‘rule of 78’, a method that calculates how much interest has been earned at any stage during repayment of a fixed-interest loan.
The principal component of the payment is not be tax-deductible.
Commercial hire purchase will be more attractive than a lease where the borrower has some equity in the asset being financed. The cost of the asset will be depreciable under a hire purchase contract, including the owner’s contribution, even though only part of this amount is financed using debt. However, under an equivalent lease contract the lessee’s contribution will not be depreciable because the lessee will technically not own the asset. Only an owner can claim a deduction for depreciation.
Borrowing in SMSFs
For many years SMSFs could not borrow except in limited specified circumstances. This changed in 2007 when the Government announced new rules for SMSF borrowing.
For new borrowings the rules are now as follows:
- single acquirable asset. Only one asset, or set of identical assets (example a parcel of shares in a listed company, listed trust, or other assets that have economically identical qualities) is permitted in each instalment trust arrangement, and which must be dealt with as if they are one asset (for example, that parcel of shares cannot be sold gradually over time, and if sold all must be sold; it’s all or nothing). This rule is very restrictive for shares and similar securities but of no real effect for real estate;
- capital improvement Borrowings cannot improve the asset, but can be used to maintain or repair the asset to maintain its functional value. This is particularly relevant to real estate and, for example, an SMSF cannot borrow to buy an old run down building and then borrow again to knock it down and build a new one. But a SMSF can borrow to repair or maintain a property to maintain its functional value;
- lender’s recourse. This is limited to the particular asset. Other assets cannot be charged in any way. In summary, a charge may be given over an asset acquired through a borrowing arrangement to secure that borrowing, but no other charge is permitted. This effects both shares and similar assets, and real estate;
- replacement assets. Replacement is limited to where instalment receipts are replaced with shares or units under a takeover, merger, demerger or similar reconstruction; and
- refinancing. Loans may be refinanced, and where the loan is re-financed such that a new loan is effectively created, the new loan will be brought within the new “Lesser” refinances may not be new loans and will not be brought within the new rules, but advice is needed each time to make sure the refinancing has not created a new loan. Particular care is needed when refinancing old borrowings for more than one asset, such as a parcel of shares in listed companies. The refinancing may create a new borrowing, and therefore breach the single acquirable asset rule.
Possible planning options
One can expect some great minds to devote a lot of time and thought to how to best use these rules. Preliminary ideas from a lesser mind include:
- consider whether a SMSF borrowing is the best way to Is it possible that the asset can be acquired through some other less restrictive mode, perhaps in the GP’s family? This is sometimes our preferred option: the consequences of a SMSF becoming non-compliant are serious and we believe it is wisest to stay away from complicated areas with a high probability of causing problems;
- consider an uncontrolled unit trust, with the client’s share of the units (less than 50% and no deemed control) owned by the SMSF and the debt held at the unit trust level (specific legal advice should be sought before proceeding here);
- if a geared SMSF property redevelopment is contemplated, consider a higher debt to equity ratio, and preserve existing cash balances and future contributions (concessional and non-concessional) for the redevelopment costs. Joint venture arrangements may also be considered, although these can be messy;
- consider gearing into an uncontrolled unit trust which acquire the property and then borrow at the trust level to complete the renovation/redevelopment. This works well for co-owning surgery premises with more than three equal owners (ie no one owner controls the trust). Specific legal advice should be sought before proceeding here; and
- consider whether SMSFs may be better off gearing in large geared share trusts where the trust borrows, and is not subject to the restrictive SMSF borrowing
It is a good idea for a GP to use a separate, special purpose SMSF for a specific transaction, such as buying a property using debt. The SMSF only holds the minimum amount of benefits needed to complete the transaction, and the other benefits are held in another super fund.
Doing this limits risk, and means any non-compliance penalties will be less than otherwise may have been the case.
Capitalised interest and related party borrowings
We recommend interest be paid at a market rate when it is due, and not be capitalised. This is to preserve the commerciality of the arrangement and to maintain an arm’s length quality at all times. This arm’s length quality will be needed to comply with other aspects of the SMSF law, and is consistent with the ATO’s views as expressed in TA 2008/5.
The new rules are particularly restrictive for shares, and do not allow a parcel of shares in different companies to be held under the one instalment arrangement, and do not allow a progressive sell down of shares. For obvious reasons the “single acquirable asset” rule is less of a problem with real estate assets, which tend to be bought singularly, with fewer properties owned relative to shares.
The SMSF’s investment strategy must include borrowing to acquire investments.
A particularly simple application
One simple application has merit. Consider a forty-five year old GP couple with, say, $300,000 in super. They are concerned about their retirement prospects and, although they are in the 40% tax bracket and have statistically high incomes, they are cash poor because of the high costs of feeding, housing, educating and “holidaying” their family.
It can make sense to set up a SMSF, transfer the existing $300,000 of benefits in, pay future contributions in, and then borrow say $500,000 to complete the purchase of a $800,000 property. The property is then rented out, with the rent income covering the outgoings and the interest, with a bit of help from contributions. The expected capital gains drive this investment, and the trick is to not realise the capital gains until the SMSF is in pension mode, ie until say age 60 in 15 years time, so that the bulk of the return is capital gains tax free.
This advantage overwhelms the disadvantage of low debt deductibility in the SMSF.
GPs who implemented strategies like this when the SMSF borrowing rules started have by now done well. We expect GPs who implement strategies like this now will do well in the future too.
Don’t invest in apartments. There is an over-supply, and the capital gain prospects are just not there.
Some apartment developers are offering up to 10% commission to financial planners to get them to flog their stuff. If an apartment takes a 10% commission to be sold you can be sure it’s not going to be a good investment.
Some apartments will be good investments. But most won’t. So we recommend GPs play it safe by avoiding apartments completely in their SMSF’s investment strategy.
These firms provide a real alternative to traditional bank finance. Companies such as Aussie Home Loans and RAMS now account for a significant share of housing finance in Australia.
GPs who have dealt with these companies report well on them. They seem to provide a good service and are able to provide lower-cost finance because they do not support the infrastructure of the larger banks. They just organize loans and are not the principal lender. The principal lenders are the larger merchant banks that are attracted by the security and low administration costs of this type of finance.
Interest charge checkers
A number of firms have entered the personal and small business financial market as interest charge checkers. Often staffed by retired bank managers, they use precise interest rate calculations to identify interest charge errors and bank charge errors. Small amounts add up, particularly if there is a pattern of overcharging. The firms collect the refunds for you.
GPs should use these services if they believe they have been overcharged on interest or bank charges. There are also some good software packages available that do the checking for you.