Income versus Capital Growth and Tax Planning
Generally investments are purchased for their income producing potential or because the capital value is expected to grow over time. Income can come in the form of interest from cash and fixed interest assets, dividends from shares or rental from property. Capital growth can come from shares and property growing in asset base value. When comparing interest income investments with those producing capital growth it is important to compare total return from each.
Interest Income Investments
Interest income investments include bank deposits, mortgages and debentures with major finance companies. The main advantage of these methods of investment is that the original capital invested is more secure. This is because the investment organisation takes all the investment risks and guarantees to pay back the capital at the end of the period of investment. They may pay a defined income return for a specified period, so the rate of return is known in advance.
Two disadvantages of interest income are that:
- The return is fully taxable in the year in which the interest is received
- There are no tax breaks available.
Additionally, the original capital does not usually grow in value so the investment does not have the potential to maintain its purchasing power against inflation. Thus, interest income investments provide good security and may provide a defined income stream for a time period, but they are not tax efficient and their value does not grow over time.
Rental Property and Depreciation Allowances
Purchasing property, either directly or through a unit trust or master fund, provides rental income which is deemed assessable. Thus any expenses or losses which are incurred in gaining that income are tax deductible. Three of the major deductions are: interest on borrowings, building allowances (for new buildings), and depreciation allowances (for fixtures and fittings).
An allowable deduction for new investment properties is depreciation on the building. Each year an amount representing 2.5% to 4% of the cost of the building (the rate depends on the year of purchase) is allowed as a tax deduction. Unit trusts or master funds which hold newly built property are able to distribute this amount to investors’ tax free. Thus, this source of income is more tax effective than interest income.
Depreciation allowances are also available for building fixtures and fittings, and can be distributed to investors. This type of allowance is not completely tax free, because when the investment is sold, the depreciation allowance reduces the cost base of the asset, and increases the amount on which capital gains tax is payable. Therefore, tax is only deferred to the point of sale of the asset, not eliminated.