Many people are attracted to borrowing to invest in property because of negative gearing tax benefits. That is, the (income) loss that an investment property generates helps reduce the amount of tax you pay on your salary or business income.
However, investing in shares also offers unique tax advantages.
I thought it would be interesting to quantify and compare the taxation outcomes of these two investment options.
Taxation of share market investments
Investing in shares can result in some attractive tax outcomes.
Australia’s imputation system, which was introduced by the Hawke-Keating government in 1987, is unique to Australia. It seeks to avoid the double taxation of corporate profits. It does that by giving shareholders a credit (called franking credit) for the tax that the company has paid.
For example, if a listed company makes a net profit of $100, it will pay tax at the flat rate of 30%, so its profit after tax is $70. If it pays the profit out as a dividend to shareholders, the shareholders will receive $70 in cash and a franking credit of $30.
Therefore, if the shareholder has no other taxable income, when they lodge their personal tax return, the $30 franking credits will be refunded, meaning that shareholder has received $100 in total (being $70 dividend plus $30 tax refund).
Therefore, investing in Australian shares which pay franked dividends is particularly attractive to taxpayers that have low tax rates such as super funds, family trusts that have adult beneficiaries with low taxable incomes, and so forth.
Even if you are on the highest marginal income tax rate, you are only going to pay 17% of tax on (fully franked) dividend income, because the company has already paid 30%.
If you invest in international shares, and Australia has a tax treaty with the country where the shares are listed, you may be able to claim a foreign income tax offset for the tax that you have been deemed to pay in that country. Although, these credits are not nearly as generous as the Australian imputation system.
Capital gains tax applies to share investments. If you hold shares for more than 12 months, you will be entitled to the 50% CGT discount, which means only half of the net capital gain will be included in your taxable income.
As a rule of thumb, you can calculate your CGT liability by multiplying the net capital gain by 23.5% (being half of the top marginal tax rate including the Medicare levy; 47%).
Perhaps the biggest advantages of investing in shares from a CGT perspective is the ability to (1) progressively sell and (2) nominate which parcel of shares you are selling.
Selling shares progressively over multiple tax years can help minimise or even avoid crystalising a CGT liability. This benefit cannot be understated.
Selecting which method you use to calculate your CGT liability (e.g., FIFO, LIFO, HIFO, as explained here) can also help minimise CGT liabilities.
Share investments are very flexible which allows you (or more correctly, your holistic accountant) to proactively minimise your taxation liabilities.
Interest and other deductions
If you borrow to invest in shares, the interest you pay in respect to those borrowings will be tax deductible, just like it is with property. Therefore, it is possible to negatively gear share investments, although I would caution against doing so (at least not to the same extent as property), as share markets have twice as much volatility as Australian property.
If you incur expenses that help you generate income and capital gains, such as purchasing share research or financial advice fees, you will be able to claim a tax deduction for that expense. There are some other expenses you can also claim which are listed here.
Taxation of property investments
Many investors are attracted to property due to the well-publicised negative gearing benefit, but there are several other benefits to be aware of.
Negative gearing benefits
Negative gearing means that if an investment makes an income loss (i.e., its revenue is less than its expenses including interest), you are permitted to offset that loss against other taxable income (such as salary or business income) thereby reducing the amount of overall tax you pay.
For example, if your investment property generates $30,000 of gross rental income, the property’s total expenses (rates, property management, insurance, etc.) are $8,000 and the interest expense is $60,000, then your total income loss is $38,000. If you pay the highest marginal rate of tax (47%), your negative gearing benefit will be $17,860 ($38,000 multiplied by 47%). As such, the after-tax cost of the property is reduced to $20,140 ($38,000 – $17,860).
The same CGT rules that apply to shares (as discussed above), apply to property.
Of course, the biggest difference between shares and property is that you cannot (realistically) sell a property gradually – it’s all or nothing with property. Therefore, your entire capital gain will be crystalised in one tax year.
Sidebar: I should mention that CGT isn’t a bad thing, because it means that you have made a capital gain. Whilst you may pay 23.5% of that gain in tax, you keep 76.5% of the gain. Making the highest possible capital gain is the aim of investing in property.
Stamp duty is a once-off cost that you pay when you first purchase a property. In most states, the cost is equal to around 4% of a property’s value (for a property worth $1 million), except in Victoria where the cost is almost 6%! I’m going to resist the temptation to comment on the Victorian government’s woeful fiscal management. 😡
Land tax is levied each year on the value of an investor’s landholdings on 31 December. Each state has a land tax free threshold. I have previously discussed land tax in detail here.
If you make improvements to your investment property, you will be able to depreciate that expense over the asset’s useful life. For example, structural works can be depreciated at a flat rate of 2.5%.
I list all the common expenses that are tax deductible for property investors here.
Which asset class is more tax effective?
Regular readers will know that I love to dive into the numbers to look at the evidence. Therefore, I financially modelled the total impact that taxation has on investment property and share portfolios.
Because most property investors borrow to invest (negatively gear), the impact of taxation is positive overall for property investors. It increases an investor’s internal rate of return by 0.60% p.a., from 13.0% to 13.6% p.a. – around a 5% improvement. That means the value of negative gearing more than outweighs the expense of stamp duty, land tax and CGT, because negative gearing reduces the cash flow required to hold the investment i.e., the amount you contribute. A tax saving today is worth more than paying more tax in 20 years’ time.
Taxation is an overall drag on share portfolios because most share investors do not borrow to invest (i.e., no negative gearing benefit). However, imputation credits do defray some of the cost. I estimate that taxation reduces an investors internal rate of return by around 15%.
This comparison, whilst realistic, is a bit unfair because I’ve compared one geared portfolio (property) to an ungeared one (shares). Therefore, when I compared two fully geared portfolios, the shares portfolio produces the best outcomes. Negatively gearing into shares increases an investors internal rate of return by almost 44%.
Therefore, the reason property produces the best results is not because property is a better investment than shares. It is solely due to the gearing, as I concluded earlier this year.
Gearing improves investment returns because you are using someone else’s capital to invest, and you receive a tax deduction for that privilege.
Negative gearing is attractive
My analysis confirms that negative gearing is an attractive consequence of borrowing to invest in property. Of course, it is not the reason to invest in property. Your aim should be solely about building as much wealth as possible (i.e., by investing in the right property) and any tax benefits are merely a positive consequence of that decision. That said, it is important that your holistic accountant and tax-aware mortgage broker help you maximise your tax benefits.