Paying minimal tax probably appeals to most people. And as tax is often our biggest lifetime cash outflow, it might seem logical that minimising it is a great way to build wealth. However, I’m going to suggest that perhaps you need to pay more tax to build wealth. A higher tax bill typically means you have a higher income and therefore a higher borrowing capacity.
I have seen lots of people cut their nose off to spite their face by focusing on the wrong things at the wrong times. Sometimes tax minimisation is more important than borrowing capacity maximisation. However, the reverse can also be true too. You must understand when to focus on one and not the other – particularly in this very tight credit environment.
The wealth impact of minimising your taxes
Even a modest income increase can translate to a significant increase in your borrowing capacity. For example, if your taxable income increased by $37,000 from $150,000 to $187,000 it would increase the amount of tax you pay by approximately $15,000. However, I estimate that this higher income will increase your borrowing capacity by approximately $300,000. This additional borrowing capacity might be the difference between affording an entry-level investment-grade property at say $500,000 versus a higher-grade property for say $800,000. A higher-grade property should, in the long-run, result in a higher capital growth rate. The difference between the value of these two properties in 10 years’ time could easily be more than $500,000 in today’s dollars[1].
I am sure that the investor that buys the better-quality asset (at $800,000) won’t even think about the higher tax bill he had to pay 10 years earlier. This is why it’s important to take a long-term view when making financial decisions.
Minimal tax = minimal borrowing = big disadvantages?
Every now and then we receive enquiries from people that operate their own businesses and report very little taxable income (BTW, I’m not certain their tax minimisation strategies are always legal). These people then complain that the banks won’t lend them any money. I have no sympathy for people in this situation as you can’t have it both ways.
Putting aside the moral and ethical obligation to pay our fair share of taxes, we also must realise the opportunity cost resulting from self-sabotaging your own borrowing capacity. Doing so retards your ability to borrow to invest and therefore build wealth. In the past, this was less of an issue with low-doc loans. However, these days, no such options exist so if you decide to report a low taxable income then your borrowing capacity will be equally low.
Timing your tax minimisation strategies
There are several strategies that tax advisors might employ to legally reduce your taxable income including:
- Delaying the billing/receipt of income until after the end of the financial year;
- Prepaying expenses or bringing forward expenses into the current financial year;
- Claiming a portion of your personal expenses for business use e.g. home office, phone, car and so on; and
- Distributing income to people outside of your immediate family.
As the above list demonstrates, in any one year many people have the capacity to legally influence their taxable income and their decisions can have a material impact on their borrowing capacity. For example, some lenders only want to see one years’ worth of tax returns (most recent year) whereas others will work on the average of the last two years. Therefore, in order to maximise your borrowing capacity, you might decide to bill your work-in-progress before the end of the year, delay expenses and/or perhaps not claim a tax deduction for some mixed-use expenses (phone, car, etc.).
In addition, some investors can be very tax-focused, and they allow it to influence their investment selection. That is, they select the investments that have the greatest impact on their tax expense. An example of this would be investing in a new-build property because of its depreciation deductions. This approach is often short-sighted as short-term (tax) savings almost never translate to the creation of long-term wealth.
Know when to minimise your taxable (or not)
In today’s tight credit environment, it is critical for people to ascertain how much money they would like to borrow in the next one to three years and work closely with their mortgage broker and tax advisor to determine their priorities i.e. do they actually want to minimise or maximise their taxable income? Or maybe minimising your taxable income as much as possible doesn’t adversely impact your borrowing capacity to the extent that it compromises your ability to achieve your goals – in which case you can do both. The point is that you must ensure your tax planning and borrowing capacity planning are congruent.
This is something to think about before you lodge your tax return for the 2017/18 financial year. Your 2017/18 tax return will dictate your borrowing capacity until January 2020 (when lenders will start asking for your 2018/19 return). Therefore, some planning now may help you avoid future disappointment.
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[1] Ignoring the higher after tax holding costs associated with the more expensive investment property.
