NZ Herald 31 March 2007

AI like your positive attitude. But you are counting on two things being more predictable than they really are.

The first — and most important — is that your managed fund will continue to produce high returns.

I don’t know what the fund invests in, but I don’t need to know. Any fund that returns 49 per cent in a year must be invested in shares or perhaps something riskier. You don’t get returns like that on a fund that invests in high-quality bonds.

That means there must be a high likelihood that the fund’s short-term return will sometimes not just be lower than 15 per cent, but lower than zero. Market crashes happen, without warning.

What’s more, under your plan you would pull out the day of a crash — although it would probably take at least a few days to actually get out. In any case, this can be a terrible tactic. Markets often bounce back quite quickly.

Don’t get me wrong. I’m not necessarily opposed to using mortgage money to invest in a share fund or similar. I’ve thought of doing it myself.

But, as I’ve said many times before, one of the basic rules of share investing is to be in for ten years or more — regardless of what the market does.

There’s too big a chance over a shorter period that you will come out with less than you put in. On the other hand, over ten years, diversified share investments or share fund investments almost always grow, and often they grow fast.

If staying in for the long haul is rule number one for share investing, it’s got to be Rule Number One — with capitals — for investing with borrowed money, which is riskier.

Assuming you are happy with the soundness and diversification of the fund and its management, I suggest you forget your daily monitoring, and promise yourself you’ll stay in for ten years.

Hopefully, over that time, the average return on the fund will be higher than you are paying on your mortgage.

That’s where I come unstuck on borrowing to invest in shares. Long-term predictions are that share returns will average around 10 per cent. And the way mortgage interest rates are going, they might not be much lower.

I can’t be bothered with the hassle and worry if I’m likely to end up making, on average, a profit of only a few percentage points.

The second thing you are counting on is that the bank will let you pay off your mortgage without penalty.

As you say, if interest rates have risen, banks often waive the penalty when people repay fixed loans because they can earn higher interest on the money somewhere else.

But when interest rates fall they won’t be so accommodating. And I wouldn’t like to bet that rates won’t fall over the next three years.

The very fact that most banks are offering longer-term fixed loans at lower rates than shorter-term loans — see the “What they charge” table to the right of this column — suggests that the banks are expecting interest rates to fall.

Let’s do a worst-case scenario:

Your $100,000 has grown to, say, $120,000. Suddenly, the market crashes. You bail out hurriedly, and find yourself with $70,000. You try to use that to repay your fixed loan, but interest rates are falling and the bank charges a large penalty.

You are left with a debt of, say, $33,000 and nothing to show for it.

If, instead, you hang in there for a decade, chances are that you’ll come out on top.

You’re in quite a strong position to borrow to invest in shares, with no high-interest debt and no investment property, and you sound disciplined with money. I hope you also have a strong stomach for the ups and downs.

AGood news. It’s an either/or situation.

Firstly, what happens if your husband owns a share on April 1:

• If he sells it before the following March 31, either 5 per cent of its value on April 1 or dividends received plus the gain he made on sale will be added to his taxable income, whichever is lower.
• If he still owns it the following March 31, either 5 per cent of its value on April 1 or his actual return (dividends plus capital gain or loss) will be added to his taxable income, whichever is lower. If he suffers a capital loss bigger than the dividend, he will pay no tax on that share.

Secondly, what happens if he buys a share after April 1:

• If he sells it before the following March 31, either 5 per cent of its cost or dividends received plus the gain he made on sale will be added to his taxable income, whichever is lower.
• If he still owns it the following March 31, he won’t pay any tax on it that year. But the following year it will be part of his taxable portfolio.

It doesn’t make any difference whether he keeps buying and selling the same share or buys different shares.

Let’s look at an example of frequent trading. Your hubby buys $100 worth of shares in May and sells for $102 in July. He spends $105 in August, and sells for $112 later in August. He then spends $110 on September and sells for $115 in February.

He pays tax on the lower of:

• Five per cent of the costs: $100 plus $105 plus $110, which comes to $15.75, or
• His gains: $2 plus $7 plus $5, which comes to $14, plus any dividends received.

What happens if we look at the same example, but the market falls and he sells the $110 September investment for just $80 in February?

His gains are then $2 plus $7 minus $30. In other words, taking into account all his share trading for the year, plus dividends of say $5, he has suffered a loss.

In that case, he simply pays no tax on any of those share investments that year.

Note that — just like non-traders subject to the new rules who suffer a capital loss bigger than their dividend income — he can’t deduct the loss from other income, nor can he carry it forward against future income.

I can’t resist suggesting that your husband thinks hard about frequent share trading. Most people who do it end up worse off than those who buy and hold.

Even if they really can outdo the market — and many people think they can but don’t — brokerage and other transaction costs often eat up their advantage.

APerhaps, although there may be a more direct question. It’s not so much how many properties you own as whether you bought them for the purpose of selling at a profit that is relevant — although the two are probably related.

But the issue doesn’t seem to be whether Inland Revenue could catch those who should be paying the tax. I’m sure it could. It’s whether the government wants Inland Revenue to do so.

And maybe, just maybe, the government’s attitude is changing.