When it comes to investment objectives, people have different priorities. Younger investors may focus on maximising returns, while older investors are often interested in preserving their capital over the long-term so it can provide for them through retirement and for future generations.
Depending on which investment strategies you adopt, the tax implications will be different. Here is some information on how tax may impact your share portfolio.
An investment is negatively geared if it is purchased using borrowed funds and expenses related to owning the investment (for example interest on the borrowings) exceed the income it produces. Expenses that exceed income produced by the investment may be able to be claimed as a deduction against other assessable income.
While negative gearing is commonly used for investment properties, it can also be applied to other investments such as shares. We recommend you seek independent taxation advice and financial advice to confirm the risks and benefits of negative gearing before making any investment.
Tax deductibility of prepaid interest
Prepaid interest, or interest in advance, refers to fixing the interest rate on an investment loan, often at a discount, for 12 months and paying the interest normally incurred throughout the year as one upfront interest payment. Prepaid interest may be tax deductible depending on individual circumstances.
A tax deduction may arise for interest on borrowings to the extent the interest is incurred in gaining or producing assessable income (for example, interest on the money borrowed to acquire shares) and where there is a reasonable expectation that there will be assessable income which will exceed the interest expense. For prepaid expenses such as interest paid in advance, any tax deduction should generally be apportioned over the period the interest expense relates to, resulting in some of the prepaid interest expense being deductible in future income years. However, providing certain conditions are met, it may be possible to claim an immediate tax deduction for interest that is prepaid up to 12 months in advance.
Investing in shares with fully franked dividend
Investments in shares provide investors the opportunity to achieve both income, in the form of dividends, and capital growth. Many Australian companies offer franked dividend, which means that in addition to the dividend paid, the shareholder may also receive a credit (called a franking credit) for the tax already paid by the company in Australia. Australian tax resident investors who are eligible, may use these franking credits to reduce tax payable on their income.
Let's look at the potential tax consequences of a negatively geared investment portfolio. Tom had $300,000 invested in shares, which he purchased using a margin loan of $240,000. His interest expense on the margin loan, at 8 per cent per annum, would be $19,200 (representing 12 months of interest). If Tom prepaid the interest for the next 12 months, he may be able to claim a tax deduction in the year of payment.
If Tom's investment provides franked dividends of $12,000 a year, and his franking credit entitlement is $4,000, his assessable income from his investments would be $16,000 (as both the dividend and franking credit are included in assessable income). The investment would therefore have a net “loss” (for tax purposes) of $3,200 (that is, the $16,000 assessable income less the $19,200 interest deduction), which he may be able to deduct against other assessable income. Tom may be able to use the franking credits of $4,000 to offset tax payable in respect of his net taxable income.