When it comes to negative gearing and reducing your taxable income, most Australians think property.
But it is a tool that can be used for all manner of investments. And one of the other main vehicles for which negative gearing can be applied is shares.
Again, this is not a strategy that is without risk. Over the long term, the Australian share market has risen faster than inflation and it has been a good strategy for creating wealth.
But as we saw in 2008 – and in 2001, 1997 and 1987 for that matter – share markets can fall dramatically during uncertain economic times.
Debt is a tool that can turbocharge your profits if you get the timing right on investments. But it can also magnify your losses if you get it wrong.
The advantage of investing in shares rather than property is that stocks can be more easily traded. The stock exchange is a far more liquid market than property, enabling you to easily dispose of an investment or switch between companies if you want to alter your strategy.
Selling a property, on the other hand, can take weeks, months or sometimes even longer.
Negative gearing on shares works in much the same way as property, which we looked at last week.
If you borrow money to build a share portfolio, the interest on the loan is tax deductible. So it reduces your taxable income.
Some companies pay generous dividends, and so the earnings on those shares would be classed as income.
With borrowing rates so low at the moment, some investors employ a strategy where they borrow money at say 6 per cent and try to build a portfolio that pays dividends in excess of their borrowings.
They pay tax on that income. But there is nothing wrong with earning money.
Most investors, however, look for long-term capital gain. In most cases, the dividend income falls short of their borrowing costs and so they claim that as a tax deduction.
Capital gain occurs when you sell your shares for more than you’ve paid. It’s the profit. And you will pay tax on that at your marginal tax rate.
Just like property, if you hold the shares for more than 12 months, you’ll only pay capital gains tax on half the profit. It is an incentive the government has built into the tax system to encourage investors to think longer term.