Tax Tip 345: How Debt Recycling Reduces Risk

Discussion in 'Accounting & Tax' started by Terry_w, 4th Mar, 2021.

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  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    Some think debt recycling is risky. But they are confusing investing and debt recycling.

    Investing can be risky – no doubt about that. But if you are going to invest anyway debt recycling actually reduces the risk because you will have more cash in your pocket.


    Example

    Homer has $100,000 cash and $400,000 in non-deductible debt at 3% pa.

    He plans to invest $100,000 and has 2 choices about how to do it.


    Choice A

    Homer uses the $100,000 from the offset account directly investing it.

    Interest on the home loan increases because there is $100,000 less in the offset. This means $3,000 per year in extra interest is charged.


    Choice B

    Homer debt recycles $100,000 and invests it.

    There is still $3,000 in extra interest charged, but this is now deductible.

    Homer saves about $1,400 per year as a result.


    The results

    Choice A = investment returns only

    Choice B = investment returns plus $1,400


    Imagine Homer’s investment tanks and there is a $10,000 loss.

    Without debt recycling it is a $10,000 loss

    With debt recycling it is a loss of $8,600
     
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  2. Absent

    Absent Well-Known Member

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    I really want to implement debt recycling in the near future to invest into ETFs. Given the money to invest will be borrowed (debt), I was thinking that I'd DCA it at, say, $10K per month into, say, VAS and VGS (50%/50% alternating each month).

    I know that, statistically speaking, lump summing it is better, but I like the idea of setting up a strategy and sticking to it regardless of whether the money invested is debt recycled or not.

    Can this be done? Can I debt recycle using a split of, say, $100K, but DCA only $10K a month? And once I've paid down more non-deductible debt, can I recycle more (adding to the $100K) and continue to DCA? Are there any cons I'm missing?
     
  3. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    If you set it up right you can do it. If you set i up wrongly you will be mixing loans at each point.

    Seek tax advice,
     
  4. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    You are overthinking it. I worked in financial markets and there is a old adage : You are either in the market or out of the market. (ie you are either a buyer or a seller. Holding is like buying as it is a choice to not sell)

    If you think investing in VAS today is wise then assume you expect the value will not fall in the next month etc, why would you invest more in 1 month, 2 month etc at a higher value ? If you expect the price is volatile and could fall you would defer entry to the ETF. Instead you could invest $50K in each now and get the benefit of compounding and time value of entry to the market.. And consider if you want to reinvest any income in new units.

    Just make sure the borrowing is clear and also deductible.
     
  5. Absent

    Absent Well-Known Member

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    I don't know if it will fall or rise. If I did think it were going to fall though, should I just wait to buy at the bottom?
     
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  6. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    Any market investment is about timing. Entry and exit. Hence the adage - You are either a buyer or a seller.

    And many investments "saw tooth" which demonstrates that in the absence of market movements that the price rises and falls as distributions become due and on the day its paid the price falls..repeats. This is well evident with "capital stable" income securities but same applies to all div / distribution securities. Plenty of investors have bought CBA and then noted a dip in price of several dollars and asked why when a div is declared. (the date of relevance is the date the shareholder becomes entitled on a record date). The warning here is that between the record date and payment date may be a poor time to buy.

    AAA :

    upload_2021-3-4_11-20-19.png

    VAS distributions are paid quarterly in January, April, July, October and the distributions include franking credits. Check the ex-div dates and check the fall pattern.
     
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  7. toozs

    toozs Well-Known Member

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    @Terry_w @Paul@PFI
    Hey guys, what are the implications of debt recycling on PPOR CGT exemption in case one decides to sell their PPOR in future?
     
  8. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    none, generally
     
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  9. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    The loan security issue vs the loan "use" is something to check. The lender may want all loans discharged on sale of the property and taking security over shares in place of the property is problematic. The lender could sever the loan interest deductibility if they did that.
     
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  10. philC

    philC New Member

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    Trying to understand the example so please go easy on me. :)

    I'm assuming Homer saves $1,400 on choice B because of tax deductibility. Yes?

    What if Homer didn't have a job and pays $0 tax would he still save $1400 or have i understood it wrong?
     
  11. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    yes.

    Yes again, but. If Homer didn't claim the interest he might be able to use the interest to reduce CGT at a later date.
    Along these lines:

    Tax Tip 204: Better to claim an expense off income rather than CGT?
    Tax Tip 204: Better to claim an expense off income rather than CGT?
     
  12. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    Not sure I agree with the statement that debt recycling is lower risk. Such a statement in credit advice may be considered misleading as it is not a fact.

    There are two issues here and they cannot be separated.
    1. An investment ; and
    2. A debt.

    Investments rise and fall with market value. Loans dont. Loans have a floor and a ceiling which are generally identical as the loan is a fixed sum or slightly reduces with P&I payments. P&I loans assist moderate to slow building of equity if the investmnet is stable in value. It may be largely ignored but is a form of equity.
    There are really two alternative outcomes.

    1. The investment value rises
    2. The investment value falls.
    The debt has zero influence upon this. However its possible a investment is larger if a borrower can access newly borrowed funds. However they increase their market risk by doing so. That is, the investment can fall in value so it is worth less than the debt. Otherwise the debt and investment are mutually exclusive. eg Market changes to investment value dont increase or reduce debt. But higher borrowings exposes a higher level of investment risk subject to market forces. (Or a enhanced capital growth benefit)

    I dont see how a debt can reduce investment risk. As it can only increase the amount invested there is always a enhanced downside risk if a market corrects. However, if a overall strategy allowed dollar for dollar non-deductible debt to be exchanged for deductible debt that does not change investment risk. It may merely switch loans from one purpose to another. However the investment risk is enhanced if a new investmenj is made using borrowed funds in every instance.

    The defence against this is the the taxpayer may accumulate cash or equity in the home through reassignment of cashflow. That is not necessarily the case and is a independent matter and while it may be a well intentioned outcome it may not occur or if market impacts cause a fall in share values it could seriously impede the strategy. It may also mean a strategy of further equity release is encouraged in the future. That further enhanceds investment risk.

    To also suggest that using borrowed cash v saved cash (through debt recycleing) lessens risk is incorrect. The investment risk is unchanged by how the acqusition is funded. There is no benefit from borrowing $100K to invest in $100K of shares if they fall in value to $50K. All that has been magnified is a long term interest deduction. Deductions for poor value are not a productive use of capital. One of the few ways a investor may take advantage of a fall in market values is to double down after the market has fallen using the cash they recycled into other equity. But that enhances leverage. It is truly doubling down and if further market falls are sustained this will create further harm. Or enhanced value if the market rises.
    Risk and reward cant be separated.
     
  13. mr_alex

    mr_alex Well-Known Member

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    Wouldn't it be correct to say DR always reduces risk if investing whilst holding non deductible debt though?

    Say you already have a PPOR loan and commited to save and invest in shares, in every case it is riskier to leave the debt as is and not DR?
     
  14. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    I think Paul missed the point of my post. If a person was going to invest anyway it would be less risky to debt recycle than not to debt recycle as there are additional tax savings for no extra expenditure.
     
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  15. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    The investment risk does not alter although increased investmnet magnifies (market) risk. Debt has no up or downside. Investments do.
    The present trend for equity release to invest in shares is a example of enhanced risk to capital.

    The deductibility is unrelated to investment risk as deductibility doesnt shelter the capital.

    Example:
    Fred's assets $1m (shares and property each 50%)
    Debt $500K.
    Net equity is $500K

    Then Fred debt recycles and borrows a further $500K. To buy shares.
    Fred's assets are $500K property and $1m shares. Debt $1m

    Now market corrects 40%. (GFC was 60%).
    Fred's property $500K. Shares $400K Total assest $900K
    Debt is $1m
    Net equity is (100K)

    Now if Fred had $500K of cash sitting there and was always going to invest he has two choices (buy shares with cash or debt recycle and still buy shares). Enhancing his share investments enhances risk regardless of the sources of borrowing since has had magnified his investments subject to market risk.

    Fred also likley faces a liquidity issue as servicing will be impacted by 60% less share income if market correct (using the GFC example). Sure he retains a decent neg geared position but that isnt risk protected. If anything is leveraged down if the market corrects.

    To argue they will invest anyhow doesnt change the investment risk. It only enhances deductibility which impacts net income cashflows. Risk is unchanged or enhanced depending which way you look at it. Its not reduced. Tax benefits are a present day "benefit" but it doesnt alter market risk. Its like suggesting low interest rates reduce risk. It just lowers one cost of holding. It may also encourage speculative risk.

    I wouldnt want to see a statement of financial advice that says borrowing money to invest in shares reduces market risks. ASIC would hang someone and put a AFSL in jeopardy. Credit advice that overlooks the risks of market risk to investments would also be deficient. Best interests to go "all in" ? This view is being reflected by many lenders who now are insisting on financial advice supporting equity release to buy shares. Just last week I encountered one such case and it was impossible to formulate a view to satisfy the lender.

    I believe DR improves some cashflows. However if market risks are enhanced it could put other elements of cashflow from income etc at risk. Could even lead to some like Fred being unable to obtain finance or have trouble with existing debt servicing. Realising losses doesnt help Fred.
     
  16. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    I think we are talking about different things here.

    And I don't suggest or recomment anyone to invest in anything, I only advise on the tax and legal issues and let the client decide what to invest in.
     
  17. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    The question a lender asks revolves around - what happens when a risk impacted investment suffers a decline in value ? They arent expecting brokers to advise on that and are asking for financial advisers. They are at the end of the chain. Its a issue that cant truly be given sound advice since its logically correct. The adviser needs to consider the borrowers whole financial circumstance and it often contradicts the credit advice which stands as being logical in itself and makes the loan look high risk since the asset has exposure to downside risk (as much as upside risk). And for borrowers late 50s and 60s they also want to know how that loan could be repaid if that occurs and if the financial advice doesnt address it they reject. Even lenders that used to be friendly to equity-out to invest. We are now seeing such forms of financial advice as very high risk for investors suing later. Property isnt a major issue if it can be serviced but shares and ETFs etc are like a red flag at a bull.

    Several month ago they didnt seem to be asking the same questions. I wonder how brokers are seeing such loans at present ? I'm not talking $50K splits. Several hundred thousand. Several have been debt recycles.
     
  18. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    I have never seen a lender ask about this.

    Here we are talking about people borrowing to buy a property and then debt recycling by using redraw - not borrowing extra but using a redrawn amount from a loan secured by property and used to acquire the property.

    If someone borrows against property to buy shares they may want the borrower to obtain financial advice. This is a different issue and not related to this thread.
     
  19. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    We must be attracting speculative investors ! It has caused a rethink as our broker and fianncial advisers are both wasting a lot of time. It seems lenders are happier to lend for property using property equity etc but mention shares above $XXXK and they start to ask different questions. Redraw is much easier.
     
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  20. FXD

    FXD Well-Known Member

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    Not sure if following example fits DR 100%:

    - PPOR P&I loan (2.2%) limit $500K, owed balance $250K with $250K redrawable
    (no offset)
    - Investment debt (3.05%) in individuals name: $1m, lower return investment
    - Investment debt (3%) in discretionary trust (DT): $500K, higher return investment

    PPOR debt has the lowest rate so use the redraw to pay down DT investment debt (no offset)
    and receive higher monthly rental income effectively and able to stream income to non working
    spouse, which could in turn use the income to pay the total PPOR loan of $500K with interest on
    $250K now deductible.

    Just not sure if it's better to just paying off PPOR non deductible debts or do the above.

    Any thoughts or ideas around similar situ that I assume may be quite common.

    Forgot to ask the main question, there is no new purchase/investment involved, so is this still considered DR???