Not all they’re sometimes cracked up to be
A comment I overheard from a young man recently worried me. Talking about some kind of investment in race horses, and he said, “I put in $1000 a month. But I can deduct $800, so it’s hardly costing me anything.”
That’s not correct. But from other comments and letters, I get the feeling he’s not alone, that many people misunderstand how tax deductions affect investing.
Here’s a little test. Which would you prefer?:
- An investment that brings in $10,000 a year, with tax deductible expenses of $5000.
- An investment that brings in $7000 a year, with tax deductible expenses of $1000.
The first one might look more attractive. The income is higher, and the deductions are bigger. But after you deduct the $5000, you’re left with $5000 of taxable income.
With the second investment, you’re left with $6000 of taxable income. You have to pay tax on that, but you still have more money after tax.
Another key point: with a tax deduction, you spend a lot more than you get back as a tax break.
Let’s say your taxable income is $60,000, which means you are in the 30 per cent tax bracket. If you spend $1000 on something deductible, that is subtracted from the $60,000 to give you taxable income of $59,000.
Without the deduction, you would have paid 30 per cent tax — or $300 — on that last $1000 of income. With the deduction, you spent $1000 and cut your tax by $300. You’re still out of pocket by $700.
It looks a bit more favourable, in a way, if your taxable income is more than $70,000 — but only because you pay more tax. You are in the 33 per cent tax bracket. So spending $1000 on something deductible would cut your tax by $330. It still costs you $670.
And if your taxable income is between $14,001 and $48,000, you are in the 17.5 per cent tax bracket. Spending $1000 would cut your tax by just $175. It would still cost you $825.
This is where I think our young man misunderstood the situation. He seemed to think his investment was costing him only $200 a month.
But if, for example, he’s in the 30 per cent tax bracket, the $800 deduction will cut his tax by $240. He’s handing over $1000 a month, and after tax that costs him $760 — much more than he realizes. I hope those horses win.
A more common investment in which tax misunderstandings often figure is rental property.
You sometimes hear landlords say it doesn’t really matter if their rates or insurance rise, because they can deduct those expenses. They don’t seem to realise that they still pay the bulk of that money, after tax.
What’s more, landlords sometimes brag about how their property is operating at a loss — because mortgage payments, rates, insurance and maintenance exceed the rent coming in — and they can deduct that loss from their other income.
Well whoop-dee-do! They are still suffering losses. The only way such an investment can be worth doing is if they later sell the property for a higher price than they bought it for. And it has to be quite a lot higher.
The extra money they’ve put in over the years — after taking into account the value of the tax deduction — could have been earning compounding interest elsewhere. The gain must more than offset that.
If I were a landlord in this situation, I’d go soft on the bragging, and keep an anxious eye on house price trends.
Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. 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.