Fairfax has been running a series of articles (see here and here) on the collapse of Great Southern and the hardships it has caused, a timely reminder of the perils of mixing debt, investment and tax breaks. Almost every case consists of investors borrowing to invest on the advice of a trusted professional, large amounts were amounts borrowed and the investments were generally done in search of a tax break. When the investment went bad, the investors were left with huge debts that they are still struggling to pay off. From Fairfax:
“They know my loan was doctored and I didn’t meet the loan criteria, but still they pursue me,” he says.
Great Southern’s plunge into administration and infamy laid bare toxic conflicts within the accounting and financial advice professions, led to a series of explosive parliamentary hearings and, eventually, added to momentum for the royal commission now underway.
The commission has shone a spotlight on aggressive, unethical and potentially illegal behaviour by financial institutions in Australia but will not consider Great Southern.
For thousands of burned Great Southern investors like Gilham the past decade has been marked by financial devastation as Bendigo, the country’s fifth largest retail bank, determinedly pursues them over hundreds of millions of dollars in loans taken out to invest in the ill-fated forestry giant.
A Fairfax Media investigation has examined the stories of dozens of such investors, who say they were misinformed about the risks of investing in Great Southern by financial advisors who incorrectly told them the loans were non-recourse, which means if debt was called in, Great Southern was on the hook, not the investors.
It’s a timely reminder for anyone with property in a self-managed super fund.
My prediction is that we are 2-3 years away from replaying the same stories but remove Great Southern and add properties in self-managed super funds that were bought from spruikers at free seminars (often at inflated prices) and leveraged as much as possible.
I know I can’t stop you chasing tax breaks, but hopefully these rules will help to ensure that you don’t end up as another statistic:
Rule 1: Choose your investment first without regard for tax
Forget about tax, work out whether the investment is a good one or a bad one before you even think about tax. If you can’t justify an investment without incorporating some sort of tax benefit then you probably shouldn’t be investing.
You might like an investment on pretax returns and then reject it after considering the post-tax returns – but you should never do the opposite.
Rule 2: Get your structure right
It is sensible to invest using a tax-efficient structure – but you need to consider not only the financial cost but the time cost and the potential for additional liabilities/responsibilities.
Choosing between investing in your own name, a company, a trust or a self managed super fund is sensible. But, if you need to create a special structure to save yourself a few dollars in tax then consider:
- How much will you pay in accountancy/legal fees? I’m not saying don’t listen to your accountant, but you should do the numbers yourself. If the structure results in a $3,000 tax saving but a $2,500 accountancy bill, then your accountant will probably think it’s a good idea. You need to work out if the $500 extra will be worth the extra time you have to spend and the potential liabilities.
- How much extra work every year will you need to do? If you hate doing one tax return then why are you signing up to add company or self-managed super tax returns to your annual list of chores?
- If the tax rules change how much will you be out of pocket? For example, spending $5,000 upfront on a fancy structure to save $2,000 per year might leave you considerably out of pocket if the rules change.
- Are you might be taking on additional liabilities and responsibilities? For example, becoming a director has additional legal ramifications. Your structure might affect how you will be treated legally if things go badly.
Rule 3. Debt is Dangerous
Debt can make a good asset great. But, debt can never make a bad asset good, and it can make an average asset bad.
What I mean is if your investment loses money, then there is no way that having debt will make the situation any better. An asset that only returned say 2% might be disappointing if you invested in it without debt, but the investment is not disastrous. An asset that returned 2% funded by debt while you are paying 10% interest rates might be disastrous.
I am very wary of using debt to invest in anything volatile. Never use debt to get yourself a tax break. If you are taking out a margin loan then make sure you can meet the margin calls if the stock market falls.
A common example might be borrowing against an investment asset (usually tax deductible) and using that money to say reduce your home loan (not tax deductible). First, this is playing with fire from a tax perspective (it may fall foul of Part IVa of the tax code), second check the interest rates, in many cases higher interest rates mean that the benefit is negligible. And definitely don’t increase the amount you invest to access a bigger tax break. Often the equation is:
- investment goes well, save a few hundred dollars or so in tax
- investment goes badly, financial ruin
- plus potential to fall on the wrong side of the ATO
Rule 4. Never invest in an asset where the sales pitch has a major focus on tax breaks
Go back to rule number one.
Rule 5. Try not to let tax affect your decision about when to sell
There are timing benefits in when you might take a capital gain or a capital loss.
But, I’m much more comfortable selling an asset earlier than I might have preferred to take advantage of a tax situation than I am holding onto a poor investment, hoping that it doesn’t fall further while I wait for some tax advantage.
i.e. don’t hold onto a poor investment that might get worse just because you are hoping there will be a tax benefit.