Many investors choose to borrow money (usually via a margin loan) to buy shares. This strategy, although risky, can deliver healthy returns and offer opportunities for minimising tax.
In a rising market, borrowing to invest should work in your favour. In a falling market, however, it can multiply any losses; you might have to sell your shares at a loss and be left with a loan to repay. If you’re new to investing, this strategy is best avoided. You can read more here about the pros and cons of borrowing money to fund an investment.
What tax deductions are available on a margin loan?
If you borrow money to purchase an investment property you can claim the loan interest as a tax deduction, and the same rules apply when you borrow to purchase a share portfolio. The only condition is that the investment can reasonably be expected to generate assessable income in the form of dividends or capital gains (but it doesn’t have to produce income every year in order for you to be able to claim the costs).
If you use your loan partly to purchase your shares and partly for another (private) purpose, only the interest incurred on the portion used to acquire the shares can be included in your claim.
When this strategy works well, the interest expense offsets any dividend income received, meaning that any franking credits can then be used to reduce other taxable income. Meanwhile the shares increase in value and can later be sold for a profit when the taxpayer is on a lower tax rate, for example during maternity leave or in retirement. Do keep in mind, though, that it doesn’t always work out this way.
Also eligible for a tax deduction are borrowing expenses (such as establishment fees, legal expenses and stamp duty on loans) associated with the loan. If your eligible borrowing expenses come to more than $100, they must be spread over five years or the full term of the loan, whichever is shorter. Borrowing expenses under $100 can be claimed in full as a deduction in the year incurred.
Interest can be paid up to 12 months in advance for the following financial year. If you know your income will be lower next tax year (for example, due to redundancy or maternity leave), it’s well worth prepaying 12 months of interest on your margin loan before this year end as the tax deduction will be worth more while you’re on a high income.
Is minimising tax this way right for you?
It’s easy to be lured in by the promise of minimising tax through deductions, but at the end of the day the returns generated by your investment need to outweigh the interest charges on your loan – otherwise you may as well have just put the money in a shoebox under your bed. Margin loans generally come with higher interest rates, so do your sums first and consider the big picture.
You may choose to use a capital-protected borrowings strategy, whereby you are wholly or partly protected if the market value of your investment falls. Any interest paid for capital protection under this kind of arrangement is not deductible but is instead treated like a payment for a put option.
Special rules apply if you borrow within self-managed super funds, but they are extremely complex, so anyone wishing to do this should seek professional advice.
To sum up:
- If you borrow money to purchase shares, the interest on the loan and any associated borrowing expenses may be claimed as a tax deduction thereby minimising tax on the investment
- To be eligible for this deduction, the investment must be reasonably expected to produce income through dividends, capital gains or both, but it doesn’t have to generate income every tax year
- This can be a risky strategy because any losses will be magnified, so approach it with caution, especially if you’re a new investor. Your aim is for the investment to return more than enough to cover your interest costs on the loan, regardless of any tax deductions
- You can pay interest on your margin loan up to 12 months in advance. It’s worth doing this during a high-income year when you know your income will be lower the following year since you’ll receive a better rate on the tax deduction when your income is higher
- It’s possible to protect your initial investment, at least in part, with a capital-protected borrowings strategy, but interest payments on this are not eligible for a tax deduction