Fairfax newspapers have been running a series of articles (see here and here) on the collapse of Great Southern and the hardships it has caused, a timely reminder of the perils of mixing debt, investment and tax breaks. Almost every case consists of investors borrowing to invest on the advice of a trusted professional, usually in search of a tax break. When the investment went bad, the investors were left with huge debts that many are still struggling to pay off. From the Fairfax articles:
"Great Southern’s plunge into administration and infamy laid bare toxic conflicts within the accounting and financial advice professions, led to a series of explosive parliamentary hearings and, eventually, added to momentum for the royal commission now underway. The commission has shone a spotlight on aggressive, unethical and potentially illegal behaviour by financial institutions in Australia but will not consider Great Southern ...
A Fairfax Media investigation has examined the stories of dozens of such investors, who say they were misinformed about the risks of investing in Great Southern by financial advisors who incorrectly told them the loans were non-recourse, which means if debt was called in, Great Southern was on the hook, not the investors."
It’s a timely reminder for anyone with property in an SMSF. My prediction is that we are two to three years away from replaying similar stories on properties in SMSFs that were bought from spruikers at free seminars and leveraged as much as possible.
These rules are designed to minimise the chasing of tax breaks and people becoming another statistic:
Rule 1: Choose your investment first without regard for tax
Forget about tax. Work out whether the investment is good or bad before you even think about tax. If you can’t justify an investment without incorporating some sort of tax benefit then you probably shouldn’t be investing. You might like an investment on pre-tax returns and then reject it after considering the post-tax returns, but you should never do the opposite.
Rule 2: Get your structure right
It is sensible to invest using a tax-efficient structure, but you need to consider not only the financial cost but the time cost and the potential for additional liabilities or responsibilities.
Choosing between investing in your own name, a company, a trust or an SMSF is sensible. But, if you need to create a special structure to save yourself a few dollars in tax then consider:
- How much will you pay in accountancy or legal fees? I’m not saying don’t listen to your accountant, but you should do the numbers yourself. If the structure results in a $3,000 tax saving but a $2,500 accountancy bill, then your accountant will probably think it’s a good idea. You need to work out if $500 will be worth the extra time and the potential liabilities.
- How much extra work every year will you need to do? If you hate doing one tax return then why are you signing up to add company or SMSF tax returns to your annual list of chores?
- If the tax rules change, how much will you be out of pocket? For example, spending $5,000 upfront on a fancy structure to save $2,000 per year might leave you considerably out of pocket if the rules change.
- Are you taking on additional liabilities and responsibilities? For example, becoming a director has additional legal ramifications. Your structure might affect how you will be treated legally if things go badly.
Rule 3. Debt is dangerous
Debt can make a good asset great. But, debt can never make a bad asset good, and it can make an average asset bad.
If your investment loses money, debt will never make the situation better. An asset that only returned say 2% might be disappointing if you invested in it without debt, but the investment is not disastrous. An asset that returned 2% funded by debt costing 10% might be disastrous.
I am wary of using debt to invest in any volatile asset. Never use debt to get yourself a tax break. If you are taking out a margin loan then make sure you can meet the margin calls if the stock market falls.
A common example might be borrowing against an investment asset (usually tax deductible) and using that money to say reduce your home loan (not tax deductible). First, this is playing with fire from a tax perspective (it may fall foul of Part IVa of the tax code) and second, check the interest rates. In many cases, higher interest rates mean that the benefit is negligible. And definitely don’t increase the amount you invest to access a bigger tax break. Often the equation is:
- investment goes well, save a few hundred dollars or so in tax
- investment goes badly, financial ruin
- plus potential to fall on the wrong side of the ATO.
Rule 4. Never invest in an asset where the sales pitch has a major focus on tax breaks
Go back to rule number one.
Rule 5. Don't let tax affect your decision when to sell
There are timing benefits in when you might take a capital gain or a capital loss. But I’m much more comfortable selling an asset earlier than holding onto a poor investment hoping that it doesn’t fall further while I wait for some tax advantage. That is, don’t hold onto a poor investment that might get worse just because you are hoping there will be a tax benefit.
Damien Klassen is the Head of Investments for Nucleus Wealth. This article is general information and does not consider the circumstances of any individual.