Michael is 50, on the highest marginal tax rate and his super is currently valued at $500,000. He had seen and heard a lot about the new gearing in super opportunity, but didn’t want to tie up a considerable amount of his super in property investments. Instead he was interested in gearing into shares and managed funds. After speaking with Michael, it was agreed that based on his current savings pattern, he would not have enough saved in the future (in or out of super) to meet his expected retirement needs and the future legacies he would like to leave to family members and selected charities.
The tax-free status of super from age 60 and the need to reduce his retirement savings gap meant gearing in super was an opportunity worth exploring. Of course there were a number of other considerations that were discussed prior to agreeing on this course of action. Would Michael be better off gearing personally rather than via super? Are the investments positively or negatively geared? What rate of return is achieved and what level of franking is involved? What is the interest rate being charged? Will Michael need access to the funds, making gearing in super inappropriate?
The strategy
It was decided that Michael would use $200,000 of cash investments in his self-managed super fund (SMSF) to apply towards a super geared portfolio, and borrow an additional $200,000 at 10.5 per cent interest. At a 50 per cent loan to value ratio (LVR), this gave him $400,000 to invest. The mixture of investments chosen is projected to return 4 per cent income (80 per cent franked) and 5 per cent growth each year.
Any surplus income from this portfolio (after allowing for interest and tax) would be reinvested on a non-geared basis. Over the next 10 years, and after allowing for capital gains tax (CGT) of $27,269 and repayment of the loan in 10 years’ time, the portfolio is anticipated to be valued at $491,361. If Michael employed the same strategy personally (outside super) the portfolio would have been valued at only $430,338 in 10 years’ time.
The 2008 Budget
What is now important to consider is the 2008 Federal Budget change to the interest deductibility rules for capital protected loans and whether it requires a change in Michael’s strategy. A limited recourse loan (such as gearing in super) falls within the definition of capital protected loans in the relevant tax legislation, although the legislation only applies to shares and units in trusts. There is no impact for property loans.
Where a capital protected loan exists and there is no specific capital protection cost specified, part of the interest cost for the loan may be denied as a tax deduction. Previously, the amount to be denied was that amount in excess of the relevant Reserve Bank of Australia (RBA) indicator rate. But on Budget night the government changed the relevant RBA indicator rate from the “personal unsecured loans– variable rate” (14.65 per cent) to the “variable rate for standard housing loans” (9.4 per cent).
As a result, if gearing in super is undertaken using margin lending, where the underlying assets will be shares and managed funds, there is (depending upon the interest rate) the potential for some of the interest to be denied as a tax deduction to the super fund. Importantly, any amount denied will form part of the cost base of the relevant assets when determining potential CGT consequences on sale.
For Michael, the result of this gearing-in-super scenario, when comparing full interest deductibility in super to only partial deductibility (up to the RBA indicator rate), is shown above. The differences are not considerable – $2674 over 10 years, and Michael is still considerably better off than gearing personally. The CGT impact will not arise if he has moved into pension phase at the time the asset sales occur.
Of course, the tax considerations are only one thing to take into account. It is the client’s overall objectives and risk profile that will determine if gearing inside super is appropriate.
