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Debt recycling

Discussion in 'Finance & Banking' started by dkmc, 2nd Aug, 2007.

  1. dkmc

    dkmc Well-Known Member

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    Can someone explain this technique to me with an example

    Say you have a ppor valued at 400k
    and loans of 250k

    revalue to 80% - = 230k of available equity - borrowed at 7.37%

    2 scenarios
    a) put it into something +vely geared - like navra fund
    b) put it into something -vely geared - like a new property

    Can someone explain the flow of money in these 2 situations

    Is there any point putting it into something into -vely geared property
    cheers
    dkmc
     
  2. nitro-nige

    nitro-nige Well-Known Member

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    DKMC

    Do you have another form of income?
    If so negative gearing would be a tax incentive.

    Nige.
     
  3. coopranos

    coopranos Well-Known Member

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    My understanding of debt recycling:
    Take income from +ve cashflow investments and put into non-deductible debt, then withdraw immediately from non-deductible debt and invest in income producing assets, thus making previously non-deductible debt deductible (to the portion that was used to invest in income producing assets).
    ie - $10k dividend from your $100k share portfolio (or perhaps the profit on the sale of some shares). Put this into your PPOR loan that has a redraw facility. Immediately redraw the amount you put in back into more shares. This $10k (or rather the interest on this $10k) becomes deductible, whereas before it was non-deductible. Next time you get a dividend you get not only $10k (assuming same divs) but also the div on the $10k you invested last year, so maybe $11k total.
    Repeat until you are fully deductible.
     
  4. Rob G.

    Rob G. Well-Known Member

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    PLEASE CORRECT ME IF I AM WRONG ......

    I believe that the ATO deems the repayment to be in proportion, so doesn't this method lose its effectiveness as the deductible proportion gets bigger ?

    e.g.

    Start with 100K non-deductible loan. Pay off 10k & redraw for investment that will derive assessable income means 10% ($10k) of loan is deductible.

    BUT when you next pay back in $10k, the ATO will deem that $9k is off the non-deductible part & $1k reduces your deductible. Redraw $10k for investment & now you have $81k non-deductible & $19k deductible. The problem is you are using borrowings of $20k for investment and yet only getting deductions for interest on $19k.

    Each successive repayment & redraw for income loses some effectiveness.

    Is this correct ?

    And if it is then starting with a 10% deductible $100k loan, repaying $10k & redrawing $10k for private purposes leaves you with $9k of deductible loan out of the $100k even if you had only parked private money there before withdrawing again - you have compromised you deductible part again.

    Have I missed something ??? It appears that redraw contaminates deductibility to me.

    I much prefer to keep separate accounts for flexibility and makes accounting at tax time very simple.

    Cheers,

    Rob
     
  5. Rod_WA

    Rod_WA Well-Known Member

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    Be very careful here. You need to keep your borrowings clearly separated, and the cleanest way to do this is with a separate loan for investment purposes, and NOT by using the redraw facility of your PPOR loan (or an offset savings account against the PPOR loan, for that matter).
    Set up a line of credit, against the equity in your PPOR, and use these borrowings to purchase shares/MFs. Then put the dividends into your PPOR loan. As the equity in the PPOR grows (and the loan value drops due to P&I payments + dividends), increase the LOC and buy more investments.
    Setting up an LOC is very simple, see your PPOR lender (as they already have the PPOR title whilst it is mortgaged to them), and avoid paying establishment fees on the LOC... it will take a few weeks, but is well worth the effort, and far easier to defend when the ATO comes knocking.
     
  6. Rod_WA

    Rod_WA Well-Known Member

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    Agreed in whole.
     
  7. dkmc

    dkmc Well-Known Member

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    Ok thanks for all the posts this helps clear things up
    So the key is that when you borrow against extra equity
    It has to return well above the 7.3% or so - preferably income

    Rod - Using the LOC seems a much better idea than a redraw account.
     
  8. tailcat

    tailcat Well-Known Member

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    Is this a simple question of asking or do you have to go through the full loan application process? (Anybody know specifically about Westpac?)

    Tailcat
     
  9. nitro-nige

    nitro-nige Well-Known Member

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    Are you saying that it has to be above 7.3% to cover the interest on the LOC loan?
     
  10. Rob G.

    Rob G. Well-Known Member

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    If you have no other assessable income source then negatively gearing is not wise - so your INCOME return for tax purposes must at least equal your deductible interest expenses or 7.3% in this case.

    Don't foget up-front investment loan establishment fees may be deductible over the life of the loan or 5 years whichever is the shorter (or fully if less than $100).

    If you are negatively gearing, you are relying on the capital appreciation making the investment financially viable.

    ***HOWEVER*** if you are likely to have to realise the asset in the forseeable future then you should factor in CGT which erodes your returns. This is particularly important in the current market if margin calls are likely !!!

    Welcome to the world of tax effect accounting.

    Cheers,

    Rob
     
  11. MiddleClassMonkey

    MiddleClassMonkey Well-Known Member

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    Rod, I'm currently looking at a new LOC loan, and the description reads "Redraw Facility: Redraw available at no cost". How is redraw facility and LOC different?

    The loan above is specifically a LOC loan, but the wording used suggests it's just a redraw facility?

    If it had both features (LOC and redraw - is this even possible??) how do you differentiate?

    :confused:

    - MiddleClassMonkey
     
  12. Nigel Ward

    Nigel Ward Team InvestEd

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    Redraw facilities can be toxic to tax deductibility. Talk to your accountant.

    Cheers
    N.
     
  13. dkmc

    dkmc Well-Known Member

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    Yes I do have other income in a job
    but with this debt recycling - extracting equity and putting it into an investement returning greater than 7.3% preferably income

    With the positive gearing scenario
    I cant see any low risk way of doing it
    bank shares yield 4-5%
    Property trusts 5-7%

    Navra fits the mould
    But I'd be weary of putting 200k into just navra - in terms of risk management
    What if the market returned -5% and navra was down 4% with minimal income. We havent seen it tested in a bear market

    Look at macquarie fortress notes - they were aiming for 11%

    In the negative gearing scenario
    You are relying on Capital gains of the IP or growth shares which may or may not happen. With property you could gear more
    Youd have to sell at sometime to help pay down the home loan
    otherwise tax wise deductibility will get messy


    Either way I see it, you are adding significant risk by debt recycling
    to something that people see as a safe haven - their ppor

    Please correct me if im wrong
     
  14. Rob G.

    Rob G. Well-Known Member

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    Exactly.

    High returns involve high risk.

    Borrowing means you must pay interest regardless of your interest returns. But it gets access to more capital than you could normally afford.

    Gearing amplifies returns AND losses.

    Remember that there is usually not much capital growth in income funds and yet you have risk AND your capital *might* be eroded by inflation.

    I really recommend you chat to a financial planner who will gauge your situation and appetite for risk.

    Cheers,

    Rob
     
  15. Leandro

    Leandro Well-Known Member

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    Steve N usually shows in his presentations, the results of his back testing in all sorts of markets. His approach relies on volatility, not whether stocks are going up or down.


    How is this any different, to someone pulling out equity from one property to invest in another?
     
  16. Leandro

    Leandro Well-Known Member

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    I wouldn't exactly call investing in an income fund like Navra which trades blue chip Australian companies high risk! Sure there is risk, but that is the case with any investment.

    This makes no sense at all! Interest gives returns?! Affording capital??

    There isn't much capital growth because it is designed to produce income. If inflation is increasing, it would be most likely that business reveneues would be increasing too, which would usually push up share prices and your unit prices. Do others see this as a real risk?

    cheers
     
  17. coopranos

    coopranos Well-Known Member

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    No arguments here about it not being clean, but the question was to explain debt recycling - turning non-deductible debt into deductible debt legally.
    what you describe is loan structuring. Debt can still be used with the structure you describe (although it is messy no doubt)
     
  18. Rod_WA

    Rod_WA Well-Known Member

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    There is nothing special or clever about an LOC with Redraw - it has to have redraw or it's not a line of credit!!! ie there's no point having an LOC and not being able to draw from it!

    Not quite true. If the investment is shares that pay franked dividends, then the franking credit really brings down the required investment return.
    For example, fully franked shares only require to return 70% of the LOC interest rate to be cashflow neutral after tax,
    eg an LOC rate of 7.3% (good rate, by the way) requires a fully franked dividend of 5.11% to not cost a cent (after tax!).
    And - any capital growth on the shares is yours.

    This is a really important point, I reckon. Find a share that pays near 5% fully franked dividend (hello big four banks!) and the shares virtually pay for themselves
    (you just need to manage the cashflow, ie monthly interest but six-monthly dividends).
     
  19. Rob G.

    Rob G. Well-Known Member

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    I think the original question was running 2 scenarios & explaining the money flow ?

    1. Positively gearing into an income-type fund.

    2. Negatively gear into property (or secutities ?) for capital growth.

    Both are very valid strategies - for a particular purpose & you need to decide **YOUR** objectives.

    In both cases, debt interest may be deductible if to produce assessable income (e.g. rent or distributions).

    Cash flow and possibly franking credits are an advantage of option 1.

    Capital appreciation is crucial to option 2 and there is an advantage of deferred and concessional rate CGT.

    Most people alternate or carry both types in their portfolios at different stages as appropriate to their situation.

    The debt funding adds risk (by amplifying gains & losses) to ANY investment - just add to taste !!!

    Cheers,

    Rob

    PS This is beginning to sound like a financial planning lecture which was not intended. It is **YOUR** responsibility to find advice specific to your situation.
     
  20. Rod_WA

    Rod_WA Well-Known Member

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    Positive gearing is not something that anyone can guarantee when we get started on an investment against borrowed funds - otherwise everyone would borrow to the hilt and invest in it and we'd all be rich.

    But I see two main intentions of negative gearing (anyone may seek one or both of these outcomes, biases to income or growth):

    1. Negative gear for a period of time, aiming for positive gearing soon into the future (due to rising dividends or rent), hoping meanwhile to manage the cashflow shortfall while it's negatively geared - in this case, you don't need to focus on the capital value of the investment, just hope it rises for long term additional benefit (a LOC has the distinct additional benefit over a margin loan of not suffering a margin call);

    2. Negative gear hoping for capital growth, and manage the larger cashflow shortfall associated with growth assets (since income is often much lower, eg BHP yield is 1.3%).

    Of course, a blend of both is useful.

    Yes, you are adding some risk, but with risk comes potential reward. And your risk appetite is the key to how far you go. For some people, paying off the PPOR and being free of debt is a viable strategy (overly cautious for many, including most on this forum ... isn't that why they're here).

    I reckon borrowing in a line of credit and investing in both growth and income assets is not considerably risky. For example, building equity in your PPOR and moving this to a LOC allows you to buy investment assets, eg shares/funds (I'll talk IPs in a minute). If you can manage the cashflow then there is very little risk with this strategy, provided (i) you don't require the investment to be successful in a short time period (less than 5 years?) and (ii) that you plan before you invest, calculating your income and cashflow position, considering tax of course.

    If you invest carefully, you can turn your negatively geared investment into positive gearing quite quickly (eg within 2-3 years for fully franked high yield bank shares, and property trusts paying 6% need only increase in value by 25% to become self-funding [maybe less if there are significant tax-deferred components]), and the positive return can rapidly pay down your PPOR debt. That is, a bit of short term pain, for an accelerating long term gain.

    You can add significant risk by gearing up further, eg through a margin loan or by investing into geared funds. In the ML case, you can take your LOC and invest with the support of a ML, eg $100k LOC into shares/funds valued at $400k (75% LVR). Then you have a larger cashflow issue (LOC interest + higher ML interest). But such a strategy is well within the high risk tolerance of many investors.

    Of course, the real power of debt recycling kicks in when your investment income is paying down your PPOR at the same time your PPOR is increasing in value - then you have the debt recycling golden goose: you can increase your investment LOC against your PPOR equity at an accelerating rate.

    IPs? I have nothing against them (I have one). Of course, the bank won't margin call your IP, and you can LVR > 80%. But can you sell down an IP if you need to? How many years until positive gearing? Do you need an income fund to support your cashflow shortfall? And the biggest question for me: asset allocation (why go heavier into property, when there are other investment classes? eg I have PPOR + IP worth nearly two times my share portfolio, so surely I should build my share portfolio before I build more houses).

    Disclaimer: Just a few late night thoughts from a punter with no AFSL, hope they help.