Money
Issue No. 14 - December/January 2004
Gearing Strategy
by Tony Catt
Investors concerned about the uncertain outlook for the share and property markets should consider reviewing their gearing strategies. Depending upon their tolerance to risk, many investors may feel uncomfortable about the extent of their gearing.
Gearing is a way for investors to gain much higher exposure to the share and property markets than would be possible without borrowing. This extra exposure magnifies capital growth when a market is rising, but does the same to losses when a market is falling.
There are three fundamental levels of gearing, each with different levels of risk and tax benefits.
- Negative gearing is when an investment’s borrowing cost and other non—capital costs exceed income from the investment. The shortfall is tax deductible against an investor’s other income. Obviously, negative gearing has the highest level of risk for an investor because income from another source, most often from a salary, is needed to meet the interest payments. The tax benefits of negative gearing are higher than for lower levels of gearing.
- Neutral gearing is when an investment’s borrowing cost and other non—capital expenses exactly equal its income. Although the investment’s income is taxable, the borrowing costs are tax deductible. Even after tax, the investor is in a neutral or balanced position. Many investors are willing to forgo the extra tax benefit of negative gearing to reduce their risks in uncertain times through neutral gearing.
- Positive gearing is when an investment’s income exceeds its borrowing cost. The borrowing and other non—capital costs are, of course, still deductible with positive gearing, but positive gearing has less tax benefit.
Consider an extremely simplified example of neutral gearing by an investor with a 48.5 per cent marginal rate. This investor takes a $300,000 interest—only loan at 6.5% to buy an investment. The interest costs is $19,500 a year. (we assume for this ex...
