Successful investors know that capital gains are the way to true wealth
Successful investors know that capital gains are the way to true wealth. Firstly you do not pay the tax until you sell the asset. No sale, no tax. The capital gains tax system reflects the fact that investors must be rewarded for risk, not punished by excessive taxation. Capital gains taxes for individuals are taxed at only half the rate for assets held for greater than twelve months.
Successful investors know that there is a tremendous tax advantage for borrowing for investment. They know the tax disparity that exists between the taxation of interest deductions and capital gains. They know interest is deductible at full taxable rates while capital gains are taxed at only half the taxable rates if the asset is held for twelve months or more. I cannot stress enough how important this is to wealth creation.
For example let’s assume we purchase a property that costs us $400,000 after all settlement costs and stamp duty. Assume we are able to borrow the entire amount because we have sufficient equity in our home. Let’s assume we get rent of 5% net yield after expenses (rates etc). This would equal a net yield of approximately $20,000. Our interest expense is 7.5% (i.e. $30,000) paid interest only. I will ignore non-cash deductions (depreciation) for the purpose of this illustration. Let’s assume that just after twelve months and one day we sell the property and we net $410,000 after sales fees and settlement costs. On a pre-tax basis, what has been the change in our net worth? It has been zero. We made a gain on the sale of the property of $10,000 but our interest costs exceeded our net rent by $10,000, resulting in no net gain on a pre-tax basis.
However the tax treatment of interest expenses and capital gains results in a different change in our net worth on an after tax basis.
I will assume for this example we are in the top tax bracket of 46.5% (45% plus 1.5% Medicare Levy). If we make a loss on our rental activities we are able to deduct the $10,000 net operating loss against our other income. By deducting $10,000 against our other income we are able to get a refund from the ATO of $4,650, meaning our after tax operating loss is $5,350.
We are also required to pay tax on the capital gain. Because we held the asset for greater that twelve months we only include half the gain in our income. We therefore include a total of $5,000 in our income. On the top rate of 46.5%, our tax payable is $2,325.
While on a pre-tax basis there was no net gain or loss, the ability to deduct borrowing expenses at full tax rates while only paying capital gains tax on half the gains highlights the tremendous benefits available to those who borrow for capital investment. The taxpayers help subsidise your activities.
With all the tremendous subsidies available to borrowers it is surprising that more people do not use finance to invest. Fortunately for those who want to use finance to create wealth few people understand the game, leaving the huge subsidies to those people that do.