Sunday, August 24, 2008

Margin Lending Tips

1. Beat rising interest rates
Prepaying interest on a margin loan may produce interest savings in a rising interest rate environment. By locking at a competitive fixed interest rate for three, six or nine months, potential variable rate rises over the rest of the financial year can be avoided.

2. Can you claim 'professional trader' deductions?
Those who claim share trading as their profession rather than just being an investor must convince the Australian Taxation Office before they can claim trading losses as tax deductions. The ATO warns there are strict criteria to be met for someone to be classed as a share trader following confusion amongst investors who have incurred losses and then tried to offset these against their other income.

3. Caution needed on protected equity loans
Protected equity loan products allow investors to gain leveraged exposure to the sharemarket with a built-in safety net if their portfolio stocks take a dive. Investors can't lose their base capital but can keep dividends and capital gains. They also benefit from tax concessions with 100 per cent deductibility for their interest and capital protection costs. But not all financial planners and tax experts are convinced that these products are the best way to achieve a solid investment return. They say their high buy-in costs and uncertainty about when the Tax Office might change the deductibility treatment make them unattractive. Experts say the costs can run as high as 17 per cent in addition to paying loan interest when investors pay for embedded put options to protect the products' downside.

4. Don't try the prepay fiddle
If focussing on the tax benefits of prepaid interest, don't try and pull a swifty by taking out a loan, prepaying interest, then cancelling the loan and getting a refund of the interest after claiming the deduction. It won't work. Prepaid interest cannot be refunded. As a tax strategy, margin loans and prepaying interest are only beneficial if you plan on actually investing the borrowed funds.

5. Establishment fee protection
Under a protected equity loan arrangement, some lenders include the value of the establishment fee in the capital guaranteed amount. For example, if you borrow and invest $100,000 and $1000 is taken out in establishment fees, some lenders will still provide a capital guarantee over $100,000, others will only guarantee $99,000.

6. Fixed interest rates
Interest rates on protected equity products are fixed but not necessarily for the full term of the loan. Some products have a rate fixed for the full term, others reset the fixed rate each year of the loan term. These resets will reflect the interest rate environment at the time.

7. Is the interest on protected equity loans tax deductible?
There has been much debate about the deductibility of the interest payments on capital protected loans because of the difficulty in distinguishing between the capital protection component and pure loan interest component of the payments. Only the interest component is tax deductible. The amount of interest available for deduction will be the lower of:

* the amount determined by the Reserve Bank's Indicator Rate for personal unsecured loans
* the amount determined on a sliding scale depending on the term of the product (85 per cent for five years, 82.5 per cent for four years, 80 per cent for three years, 72.5 per cent for two years and 60 per cent for one year)

8. Loans for interest
Some protected equity lenders offer a separate, secondary loan to cover the first year's interest payment on a protected equity loan. These loans will have different rates, terms and conditions than the primary investment loan.

9. Prepay interest for tax benefits
Most borrowers are able to claim margin loan interest and other costs of investment as tax deductions - depending on personal circumstances. Prepaying twelve months in advance just before the end of the tax year is the way to make the most of the tax benefits. By paying a year's interest in June, the deduction can be enjoyed almost immediately in your upcoming tax return in July. But be aware that this really only amounts to tax deferment, not tax reduction. Investors are only bringing forward a tax deduction by one year, not reducing overall tax in the long run.

10. Tax advantages of borrowing to invest
There are several tax advantages when you borrow to invest in shares:

* you can claim your interest payments against your taxable income and if you earn less on the share investments than the interest payments you can claim the interest against other assessable income;
* you can prepay the interest up to 13 months ahead, prior to June 30, which is helpful for cash-flow planning and also allows you to claim the deduction a full year in advance;
* you can defer any capital gains tax liability until the shares are sold;
* as you're geared into the market you will own more shares than if you had paid cash, so you will receive more dividend payments. If the shares are franked then you can offset the franking credits against your assessable income.

11. The trade off between loan cost and share growth
Protected equity lenders broadly offer two different ways to reduce the high interest costs of their capital protected loans. 'Shared upside' simply offers the borrower a lower interest rate in return for sharing any capital growth at the end of the loan term with the borrower at a set proportion, eg. 25 or 50 per cent. Alternatively, some borrowers offer investors the ability to write call options over the stocks in their loan portfolio at preset "strike" prices. The sale proceeds from these options can be used to help fund the loan interest. But this also means that if the price of a stock in the portfolio rises above the option strike price, the buyers of the call options can then buy the stock outright from the investor, leaving the investor with only the capital growth up to the strike price.

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