Mary Holm: Highly geared assets not without risk

Diversification and holding over the long term provide a safety net, which is weakened by borrowing. Photo / Getty Images

Property investors may be in more danger of a nasty fall than they realise

Q: I have been reading the discussion about weighing up property versus shares over the past few months in your Herald column.

The tax "system" is certainly geared towards investment property. As an example I know of a professional couple in their 40s who own five investment properties.

As the properties are highly geared they receive a special tax code certificate so that no PAYE is deducted from their salaries at source. Therefore 100 per cent of their earnings go towards their property investments and they do not contribute any income tax at all. I cannot see that this is possible with shares.

Their intention is to hold on to the properties long term to provide them with monthly income in their retirement. When they do eventually sell they will not be taxed on the capital gain.

An option to stop this happening is that different sources of income/loss cannot be offset against each other. Your thoughts?

A: The couple certainly do seem to be sitting pretty. I've heard of plenty of people reducing their tax in these circumstances, but paying no tax seems extreme. It implies that they have zero taxable income - that their salaries are fully offset by losses on their properties. So how do they buy the groceries?

Inland Revenue suggests they may have earlier losses that they can offset against current income. But surely they can't do that year after year. Could they be exaggerating their situation to you?

Regardless, I wonder how they justify taking all the taxpayer-funded services and contributing little or nothing. I wish more people would ask that question of those who skite about paying low taxes.

Onwards to other issues. What they are doing is actually possible with shares, too. If you borrowed heaps to buy shares and the interest and other expenses exceeded your dividend income by a large enough amount - so that you were making an annual loss - you could also arrange not to pay PAYE tax.

But that isn't common, for two reasons. Firstly lenders are reluctant to lend much if you use shares as security. It's quite possible to have a revolving credit mortgage over your home and put that money into shares, but it would probably be hard to borrow as much as your couple have borrowed.

Secondly, not many people have the stomach to borrow heavily for share investment, because shares are inherently riskier than property.

Let's say investors in shares are on a high tightrope and investors in property are on a somewhat lower one. Diversification and holding over the long term provide a safety net. Borrowing weakens the net. Your couple feel they can cope with a flimsy safety net because they're not too far off the ground.

They might, though, be in more danger of a nasty fall than they realise. What if house prices plunged the way they have in many other developed countries? What if the law is changed on taxation of capital gains? Already, property investors have lost their depreciation deduction, and there's lots of talk of capital gains being hit next.

Or what if Inland Revenue looks closely at the couple and determines they have to pay tax on their gains even under the current law? The fact they have held the properties long-term is no automatic defence against that. It all hangs on their intentions when they bought.

In the meantime - as mentioned above - they must have been paying out more in interest and other property expenses than they get in, year after year - unless they are offsetting losses from past business.

It's a clever plan only if they make big gains at the end to make up for that. While they might retire comfortably off, they might have been better off still if they had just put the money into shares over the years.

Your idea of not letting people offset losses from one source against income from another source has been discussed widely. One problem is that that would put people off starting businesses, which often suffer losses at the start. And the country needs new businesses. But maybe there's a way around that.

Come to think of it, that's yet another risk for your couple - that such a change could be introduced. And if a change like that would make it more difficult for people in their situation to dodge taxes, I expect many voters would support it.

Long-term perspective

Q: We are now well into retirement and having dabbled in both property and shares (very modestly) for over 50 years offer a few comments on comparing the two.

Property has been reasonably good from a capital gains situation, but always carried the "tenant" risk despite generous low rentals for students and young couples. But one wild party by teenagers when parents were away and another indoor rabbit breeding experience were too stressful.

After three major sharemarket downturns over the 50 years, the share return is still good from a capital gains perspective and the dividends have kept on. Occasional selective buying and selling have made the past five or six years quite fun and been profitable through the global financial crisis.

In retirement with a progressive disability, the sharemarket has been a real boon as an interest, with the additional obvious benefits of cash on demand as needed.

Personally we have found each type of investment appropriate at various ages and stages.

As time moves on, I find a share portfolio with an equal split between good quality property shares and generally reliable dividend-paying companies is a satisfactory situation.

A: It's good to have such a long-term perspective from someone who has been through bad periods in both types of investments. It sounds as if you didn't bail out in the share slumps, and that's important to success in shares.

It also seems that you get pleasure from share investing. And perhaps, years ago, you got pleasure from doing up and taking care of rentals. These things vary with personalities and, as you say, with life stages. And pleasure is an important factor in choosing an investment.

My only concern is that your "cash on demand" comment might mean you now have all your savings in shares.

It's a bit risky using shares that way. If the market dives and you need cash, you might have to sell at a horribly low price. It's a good idea to gradually move any savings you plan to spend in the next few years into bonds and cash.

Personalised accounts

Q: Should not the conversation about Treasury's options on the future of NZ Super sustainability also include the pros and cons of amending the NZ Super Fund (Cullen Fund) into a permanent institution of personal accounts, with contributions to them built into the taxation system?

The personal accounts of higher-income earners would increasingly finance their own NZ Super, and would that not eliminate the case for means testing NZ Super forever?

A: I'm not sure how or why we would turn the Cullen Fund into personal accounts.

That fund, set up in 2001, "was designed to save up money for the future cost of NZ Super", says Treasury's new "Affording Our Future" report, which considers how New Zealand can cope with an ageing population.

"Current tax dollars are placed in the fund, where they earn investment returns. The fund will eventually be used to help cover some of the costs of NZ Super. If we continue to contribute to the NZ Super Fund at the rate planned, drawdowns from the fund are expected to cover about 8 per cent of the cost of NZ Super in 2050."

Eight per cent is not much. But as the report notes, "We could increase contributions to the fund, but that would mean either increasing taxes or finding savings from somewhere else." And even 8 per cent helps.

Leaving the Cullen Fund aside, though, it seems you're interested in setting up something like a compulsory KiwiSaver scheme. "Affording Our Future" looks into that.

Under such a scheme, when people access their savings in retirement, all or part of that money might be "annuitised", says the report. That means you wouldn't be able to take the money out as a lump sum, but would receive regular payments, probably until you die. It's a feature that I think should have been in KiwiSaver all along - compulsory or not - but that's another story.

"The total amount individuals would receive in annuitised pensions plus NZ Super payments would depend on how much they had managed to save over their working lives," says the report.

"There would be many details to be worked out, of course. For example, what to do about people whose incomes are so low that requiring them to contribute to a retirement savings scheme would create a real burden. Or what to do about people who have no income at all for periods. Exemptions might need to be made for people in these categories."

The report considers the advantages of compulsory KiwiSaver compared with using the Cullen Fund to pre-pay the costs of NZ Super. "There is less risk of a future government deciding to spend the money on something else. Also, although a mandatory deduction from wages is in effect a tax, it might not feel like a tax if it is directed towards a personal retirement savings account."

But it also sees drawbacks. "Individual retirement savings accounts expose people to the risk that, at the point they are eligible to receive their funds, the market is going through a downturn." This wouldn't really matter if a person was spending their savings gradually over time. But it would matter if a large portion of the balance was converted to an annuity on a specific date.

"There are also questions about risk to the Government. If something goes wrong, and people lose most or all of their savings, will the Government feel obliged to step in to rectify the situation?"

Other drawbacks are that a compulsory scheme "might require some people to save more than they need or force them to save in a way that doesn't suit them. It might, for example, deprive people of money they would otherwise use to start a business, pay down personal debt, or undertake further study. These drawbacks need to be weighed against the benefits."

I quite agree. I would like to see the Government press ahead with its plans to automatically enrol all employees into KiwiSaver, because I think it would jolt many people into looking into the scheme and realising its value. But I hope the Government continues to give everyone the right to opt out after a few weeks.

As the report points out, KiwiSaver is not the best option for everyone.

• Mary Holm is a freelance journalist, part-time university lecturer, member of the Financial Markets Authority board, director of the Banking Ombudsman Scheme, seminar presenter and bestselling author on personal finance. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.

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