Tax considerations for margin lending

Rather than addressing these questions directly, some people think in terms of managing the tax consequences. In this article we look at how tax might influence a typical investor’s decision about borrowing to invest.

King cash flow

People who borrow to invest may favour investments that pay strong dividends. This preference for yield is usually driven by cash flow – money coming in offsets money going out. The first tip is not to rely only on dividends to meet loan interest. Remember, interest is usually payable monthly, but dividends (if paid) come only twice a year.

True costs

Generally, interest paid on an investment loan may be claimed as a tax deduction. This means the cost of borrowing may be reduced by around 30-40%, depending on your tax circumstances. Keep in mind that dividends are added to your taxable income; which could tip you into a higher tax bracket. If your aim is to invest so that interest is offset over a year, then lower dividends may be sufficient after taking tax into account.

Finding frank

Generally, local dividends come with franking credits attached. Franking credits represent tax already paid by the company. To avoid taxing the same money twice (once as company profits and then when dividends are received), franking credits may be used to reduce your tax bill (possibly resulting in a refund). Thus, some people look for investments that are expected to pay a strong dividend and a high rate of franking credits.

Avoid the drag

So far we’ve talked about picking investments that result in a close-to zero cash flow (dividends in, interest out) over a year, after tax. But this is not the only way to think about your investment choice.

Generally, if an investment is owned for at least a year, the tax on any capital gains may be discounted by 50%. Thus capital growth has two advantages; tax isn’t due until you sell the investment (or it matures) and the tax rate is usually half that paid on dividends. This means more of your money remains invested.

If you are comfortable about using income from other sources (such as wages/salary) to pay interest on the loan, it may be worth looking for investments with good prospects for capital growth instead of focusing just on dividends.

Capture to control

Whatever your aim, an important tip is to have dividends paid into the loan account. This means the loan balance will reduce over time. More importantly, it opens up scope for you to control when, and if, an additional loan and investment is appropriate. Investing is about confidence, and confidence comes with understanding your choices.

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