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Taxes Leveraged investing can boost returns - but do it prudently

It’s hard to believe that the Olympic Games will be taking place again next summer. I’m not sure what new events will be introduced, if any, but I’m all for bringing back some of the events from the past. For example, Town Planning was an event in 1928, Live Pigeon Shooting in 1900, Solo Synchronized Swimming in 1984 and Firefighting in 1900.

If they’re going to add Town Planning to the list of events, why not Extreme Ironing (yes, it’s an actual sport – search it online), Accounting or Leveraged Investing? My neighbour, James, has mastered the art of leveraged investing and would likely make the Canadian national team if there was such an Olympic event. Here’s a primer on the subject.

The math

Borrowing money to invest – or leveraged investing – will allow you to generate significant returns if your investments perform well. But leverage is a double-edged sword because a decline in the value of your investments could leave you far worse off than you might expect.

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Let’s take James as an example. He invested $10,000 of his own money and borrowed another $10,000 to invest. If he generates a 7-per-cent return on his investment, and incurs interest costs of 4 per cent, his effective pretax rate of return will be an impressive 12 per cent, assuming his marginal tax rate is 50 per cent. Check out the accompanying table for the math.

But what if James, in the same scenario, incurs a 7-per-cent loss on his investment? His effective loss will be 16 per cent. Ouch. The reason for the magnified loss is that James is not only losing money on the change in the value of his investment, but he’s incurring interest costs at the same time, making his loss even bigger.

The guidelines

  1. Leveraged investing works best if you’re in the highest marginal tax bracket. While you’ll still incur the same interest costs as those in lower tax brackets, you’ll experience greater tax savings from the interest deduction.
  2. The lower your interest costs, the more profitable leveraging can be. You’ll also find that, where your investments decline in value, your losses won’t be as severe because the interest costs result in cash savings.
  3. The loss from negative returns in a leveraging scenario are more magnified than the gains realized from positive returns – see the table. The bottom line? Stick to more conservative investments when leveraging. Higher-risk investments simply become that much riskier when adding borrowed money to the equation.
  4. Focus on higher yields. It’s important to earn high enough returns to make leveraging worthwhile. The fact is, many traditional fixed-income investments – government or corporate bonds, for example – may not cut it in this regard.
  5. Focus on the long term. If you’re going to be holding equities as part of your leveraging program, take a long-term view (10 years or more is ideal). If you’re hoping to strike it rich within a mere year or two by using leverage – don’t bother.
  6. Keep your interest deductible. Once you’ve invested the borrowed money – keep it invested. This will preserve the deductibility of your interest. Where capital has been borrowed, you run the risk of losing some of the interest deductibility if you later use that invested capital for personal purposes, including paying down debt or interest on the debt.
  7. Be sure you can sleep at night – don’t borrow too much. I generally don’t recommend borrowing more than 20 per cent of your net worth for investing. Having said this, if you’re living virtually debt-free and have not borrowed to invest, you may be giving up an opportunity to use your assets to build wealth, if you borrow prudently.

The effect of leveraged investing

No leverageLeverage: Profits earnedLeverage: Losses incurred
Personal funds invested $10,000 $10,000 $10,000
Borrowed funds invested - $10,000 $10,000
Total invested$10,000 $20,000 $20,000
Return on investment$700 $1,400 ($1,400)
Less: Interest costs - ($400) ($400)
Add: Tax savings from interest deduction - $200 $200
Net return on total investment $700 $1,200 ($1,600)
Return on personal investment (%)7.0%12.0%-16.0%
Assumptions:
Return on investment7.0%7.0%-7.0%
Rate of interest on debtN/A4.0%4.0%
Marginal tax rate50.0%50.0%50.0%

Source: Our Family Inc.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.

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