Widespread changes to superannuation for high income earners announced in the Federal Budget on 3 May have compelled many investors to review their investment strategies as they seek to ensure they are tax effective and will deliver them the necessary lump sum to fund their retirement goals.

With this in mind, a key capital growth and income investment strategy worthy of consideration in the current climate is negatively gearing into equities.

What is negative gearing?

“Gearing” simply means borrowing to invest. Negative gearing arises when interest and expenses on funds borrowed exceeds the net income obtained from the investment. If you negatively gear, your investment initially makes a loss when interest costs are taken into account which you hope you will make up with a capital gain when you sell it. In the case of equities there is also the opportunity to increase your income stream through dividends.

 Why negatively gear?

By adding borrowed funds to your own funds, which may be limited, a greater amount is available to invest and reap the potential benefits. With interest rates currently at low levels, it is understandable why many investors are taking the opportunity to boost their stakes in equities via negative gearing.

Negative gearing continues to offer a range of appealing tax advantages. For starters, high income earners can usually expect to be able to claim a tax deduction for interest payments on their loan, thereby making the loan more attractive.

In relation to equities, there are also tax advantages to be had when it comes to the income they generate. Equities provide an income stream via dividend payments. Most dividends from Australian companies are “franked” which means the company has already paid company tax of 30 per cent on its earnings. Franked dividends, which come with a franking credit (also known as imputation credits) are tax effective investments because the tax you pay on them is reduced by the amount of tax the company has already paid.

 Other factors to consider

While negatively gearing into equities is well worth considering, and particularly in the current financial environment, there are a number of factors to assess before making such a decision.

Negative gearing is borrowing to invest. It is important to ensure that you are comfortable with a change in your level of borrowing. It is also important to ensure that you have adequate funds in reserve to meet the costs associated with this borrowing.

Investing in equities should never be considered a short-term strategy. It is in fact a long-term strategy requiring, in most cases, a minimum commitment of at least five to seven years. The market does go up and down, and there are cyclical changes. However, those investors who are able to make a sustained commitment to ride through these market changes end up on the right side of the ledger.

In relation to negatively gearing into equities, it is also important to be aware of the concept of “Loan-to-Value Ratio” (LVR). The loan-to-value ratio is the amount you have loaned as a proportion of the value of your investment – in this instance, equities.

As the value of equities are recalculated on a daily basis, sometimes increasing in value, at other times falling in value, there will be changes in your LVR. If your LVR falls below a pre-determined level it triggers a “margin call”.

When a margin call is made the margin lender will require the borrower to lodge additional security, either in the form of shares/units or cash to bring the LVR back below the permitted threshold. If the borrower fails to do so within the permitted timeframe, the margin lender’s security permits them to sell some of the secured assets to reduce the loan.

For property owners, margin calls can be avoided by using the equity available through your home loan to finance the borrowing. This also has the advantage of utilising lower interest rates.

Falconer Advisers are experts at working with clients seeking to negatively gear into equities as part of a well-diversified portfolio. To find out more, please call me on 03 9600 4111 or email me on robert@falconeradvisers.com.au.