Tax Tip 2: Debt Recycling

If there is no non-deductible debt then it wouldn't really be debt recycling, but still a legitimate strategy as it allows for more money to be diverted to tax efficient entities.

 

Hi Terry. Great thread. I fully understand how debt recycling works and the tax benefits. Is there ever a worry of being margin called by a bank when debt recycling?

For example: Jim has a PPOR mortgage or 1 million dollars. He received an inheritance of $500,000 and wants to use it all to buy shares. Instead of buying the shares with the $500,000, he pays down his PPOR loan $500,000 and redraws and buys $500,000 of shares making the loan tax deductible. The share market drops 20% the next day and now his shares are worth $400,000, but his loan is $500,000. Is there a risk or being margin called in this situation?

 

No risk here since the security for the loan is the ppor and not the shares. Thats the main advantage of debt recycling over a margin loan secured with the shares.

the risk is the same as asking if the bank would foreclose on your home loan.

 

Yes it depends on what the security for the loan is

 

I sort of did this but not with 500k lol and during covid it fell below the split amount used to invest but then bounced back....but no disruption in the installment payments when it was down and no issues and now portfolio is at its peak

 

The lender wouldn't even know what you have borrowed to buy with debt recycling. They initially lend to purchase the property, but then the borrower pays the loan down and redraws and uses the money without the involvement of the bank

 

Thanks guys. That clears it up. Does the S&P500 with a dividend of 1.35% count as an income producing asset?

 

ANY dividend income for each respective holding will count to the deductibility for that parcel. However, as the income is foreign income the tax credit could be limited and there could be issues with the ability to offset the foreign income loss v australian source income. Foreign divs are different to domestic divs.

 

It is income

 

Thanks guys. I appreciate the responses. I'm just looking at the VAS average return for the last 10 years. A total return of 8.27% made up of 4.54% income and 3.66% growth. With the current high interest rate of 6.25% on my home loan am I getting a better return just paying down the home loan instead of debt recycling to buy VAS?

4.54% income - 47% tax = 2.40% + 3.66% growth = 6.06%. This is slightly lower return that saving the 6.25% interest on my home loan. There is a very good chance I am missing something here so would be interested to hear some opinions on this.

 

Hi Johnny Utah 87, the interest you pay on home loan is also tax deductible(For the debt recycle split loan portion). So in the example above assuming 47% tax rate, then net interest paid would be 6.25%-47% tax = 3.31% which is less than 6.06%

 

But that doesn't take into account the income.

on $100,000 you would be paying say $6,000 interest but receiving $4,540 in income so the loss is just $1,460 which would save tax at $1,4560 x 47%

So you would be about $800 negative.

If the shares were to grow at this amount you would still be in the negative really as if sold you would have to pay CGT on $800

so they would need to growth slightly more than the loss for the borrower to be ahead. But it might be low perhaps around 1.5% pa

 

Thanks Terry. That seems relatively safe over the long term with the VAS having 3.66% growth.

Do franking credits also increase the return in this situation?

 

VAS earnings / returns of the past are NOT a indicator of the present. Interest rates now are higher by a factor of 3 than much of the past 10 years. The expression "past performance is no indicator of future performance" should be carefully understood.

Share arkets can also be exposed to market risk. Its been a LONG time since a real correction and commentators warn of it. You said "relatively safe". Relative to what ? I would argue that when using borrowed funds you need to consider the risk the asset value falls . The loan wont.

Franking credits passed on dont enhance yield if a taxpayer does not have a low income. It reduces it since a tax shortfall based on their marginal tax rate occcurs. The franking is say 30% but Freds tax rate is say 39%. But due to some maths he faces a shortfall of more than 9%. Its 22.09% of the cash distribution.

Example. Fred earns $150K pa from work. He also produces $10,000 of VAS distributions. This came with $2772 of franking. Fred is assessed on $12772 adding $4981 tax. This is reduced by the franking credit of $2772 so a net $2209 tax shortfall is payable. $2209 as a % of $10K is 22.09%.

 

I agree with you 100%. Any investing is a risk and there is no guarantee of future returns. However if you look at the last 100 years the sharemarket has returned an average of 8%. I am happy to use this as a basis for calculating expected future returns.

 

Franking credits are a credit for tax paid so they are as good as cash really.

 

If a financial planner did that they would be finding a new career. Averages are a terrible statistic. Past performance too. Its like thinking a nuclear attack on japan is inevitable beacuse two happended in the past. Past data can ignore or overlook smoothed losses and spiked gains. The longer the period the more conerning. Behaviours 40 years ago have little or no relevance to present. Perhaps even 10 years ago. In fact franking didnt exist and neither did capital gains tax 40 years ago. Access to property equity credit has spurred leveraged investmnet to a high degree that was less common just 10 years ago. Since covid new entrants has vastly increased trades but without experience of loss making. A particular concern is that many think indexes are a asssured growth and return. They are a reflection of the market and underlying shares.
A planner must also consider the risk of loss. ASIC consider a rule of thumb of 1 event each X years. The ASX between 2008 and 2018 is a good period to consider.
The ASX's long, long road to recovery
Most investors sold down in the GFC and didnt ride the recovery and recover individual performance. They took real losses.

The ASX 200 index doesnt reflect what you are saying. 11.5 years for the index to merely recover.
ASIC consider under 15% of investors now were investors back then and 85% have no experience in market corrections.

 

So you're saying that you or any financial planner would never invest in shares because past performance can't guarantee future returns?

What I was suggesting is Peter Thornhill's approach, but instead of investing in LIC's using VAS instead. Personally I wouldn't invest 100% in VAS due to the lack of diversification. A 30/35/35 VAS/VTS/VEU split is what I aim for.

 

One thing to define in this sentence, is that '8% return' or '8% return above inflation'.

When comparing a potential return against cost of debt it is important to consider inflation as well as the tax implications.

 

No.

A financial planner cant recommend based on past performance. Same with super returns. The data on past performance is generally based on market performance with minor fund attributes. Industry super ads have been criticised by regulators for this but guess what- Industry super is a advertising media and not a fund. But if a investment is trading under its highs and is expected to track back up that could be a basis for recommendation.

Advisers should consider expected future performance and relative to other options. Imagine a planner saying you know banks rose 48% in the past 8 years. And we expect this to repeat. Why ? Agree too on diversification as this spreads risk relative to diversified indexes rather than key shares.
30% Australian Shares ASX 300 Index
35% VTS Vanguard U.S. Total Market Shares Index ETF seeks to track the performance of the CRSP US Total Market Index
35% VEU Vanguard All-World ex-U.S. Shares Index ETF seeks to track the return of the FTSE All-World ex-US Index