Is it time to negatively gear property or shares?

Some investment commentators would no doubt believe that investors who negatively gear new investment properties and shares at this time must have rocks in their head.

Residential property prices are still falling in most Australian states, and the highly volatile local share market returned a negative 6.8% in the 12 months to February.

And the Reserve Bank’s latest margin lending statistics underline the extreme reluctance of many investors to borrow to invest. Australia’s total margin lending debt, taken to gear shares, plummeted to $15 billion by December last year – the lowest level in eight years.

Just think that the margin lending debt is 64% down on the record $41.6 billion reached in December 2007 on the eve of the GFC.

Unquestionably, it would be a contrarian approach to negatively-gear your new investments. But given the depressed state of the residential property and the local sharemarket, a case could be mounted for going against the herd of investors who are cutting back on both their investment and personal borrowing.

Further, there is another powerful reason why some older, contrarian investors may decide to take bigger risks by negatively gearing their investments.

The standard annual cap on concessional superannuation contributions by members over 50 – mainly salary-sacrificed, compulsory, and deductible contributions by the self-employed – will halve to $25,000 from July. This will diminish valuable potential tax breaks for middle and higher-income earners.

And in turn, more investors are likely to consider gearing property and shares (outside super and through self-managed super funds) as a way to partly address this looming reduction in tax breaks.

The halving of these caps means that super fund members with a marginal tax rate of 46.5% will lose tax savings of up to $7875 a year from 2012-13 while those with a 38.5% marginal rate will lose up to $5875 a year. Much will depend on an investor’s circumstances.

Gear shares

Negatively geared shares provide a relatively straightforward way to help maximise tax and investment opportunities for investors that understand the greater risks involved. In short, gearing magnifies capital gains and losses.

A share is said to be negatively geared when the interest on the investment loan exceeds its dividend income – and the shortfall is deductible against the investor’s other income.

However, a phenomenon in this volatile sharemarket is that the dividend yields of some popular quality shares are markedly higher than the interest payable on investment loans once the value of franking credits are taken into account.

Ross Bird, head equity strategist for investment researcher Morningstar Australia, points out that the average forecast grossed-up yield (which includes franking credits) of the four big banks is 10.1% for 2011-12, rising to 10.8% for 2012-13. (The forecasts are by Morningstar analysts.)

And Morningstar’s forecast grossed-up yield for dividend champion Telstra is a breathtaking 12.4% for both 2011-12 and 2012-13. (The yield was even higher before the recent rise in Telstra’s share price.)

Yet investors should expect to pay a little more than 9% for a variable rate margin loan and about 8.25 to 9% for a fixed-rate loan (depending on the terms and conditions).

This means that a geared portfolio comprising of, say, the big banks and Telstra won’t be negatively geared. It will be positively geared with the dividends easily outstripping the interest on a margin loan.

However, grossed-up dividends are unlikely to exceed interest on a loan to finance a properly diversified share portfolio – depending, of course, on the level of gearing. Bird gives the example of what Morningstar classifies as its “sustainable portfolio”.

This regularly updated portfolio currently comprises: QBE, Ramsay Health Care, Telstra, Westfield Group, Westpac, Seek, JB Hi-Fi, CSL, Computershare, Commonwealth Property Fund, Cochlear, Bendigo Bank and APA. The portfolio’s forecast grossed-up yield is 7.4% for 2011-12, rising to 7.8% for 2012-13.

Bird describes this portfolio as “almost self-funding” if geared. “The portfolio is designed for moderate capital growth with a healthy income stream,” he explains.

Key points to keep in mind that even if a portfolio is not negatively geared, interest on the investment loan is tax-deductible – and the investor is getting exposure to the sharemarket when shares are still relatively cheap.

Gear property

If you believe that prices are beginning to bottom out in your selected market, now might be a good time to begin thinking about gearing a residential property investment over the next few months or so.

As reported by Property Observer, RP Data-Rismark calculates that the indicative rental yield for all capital houses was 4.4% in January. This compares to an average variable rate of 6.99% charged by the four big banks for what interest-rate researcher Canstar regards as “outstanding value” property investment loans.

Louis Christopher, managing director of SQM Research, believes another rate cut would be necessary to mark the bottom of the Sydney and Melbourne markets where auction clearances are lower than last year’s levels. However, he suspects that the Perth residential market has either bottomed or is near to it.

In all, Christopher says it is “not a bad time” for investors to begin researching for their next residential investment.

Gear through a SMSF

Sydney tax lawyer Robert Richards says gearing an investment through a self-managed super fund (SMSF) is a way to expand a fund’s assets despite the looming cut to the standard concessional contributions cap for members over 50.

Under superannuation law, SMSFs can borrow to invest subject to strict provisions. The geared asset must be held in a special trust until the final payment of the loan, and lenders cannot make a claim against any other fund assets in the event of a default.

There is plenty to consider. On one side, an SMSF-held asset will produce much lower negative-gearing tax benefits than if the asset was in the name of a top marginal taxpayer.

But once the investment’s income exceeds the interest debt, the rental income is taxed at a maximum of 15%. And the eventual capital gains are taxed at just 10% (if the asset is not sold within 12 months of purchase) or CGT-free if sold when the asset is backing the payment of a superannuation pension.

Finally, no investor should gear an investment without being aware of the risks. As Richards says: “While gearing increases the opportunity for greater capital gains, it also exposes you to greater capital losses".

This article originally appeared on SmartCompany.