Stress testing
But what happens if interest rates jump 3% to 10% in the year after the structure is established? In that case (assuming margin lending rates move similarly to 12.5%) the interest cost each year is approximately $105,000. That’s an increase of $30,000 in cash that must be found – a frightening prospect. Against the prospect of this risk must be weighed against the buffer and the growth. Firstly, the buffer will provide 2 years’ interest cover at 10%. This should give you plenty of time to plan your next move. Secondly, by the end of the second year the portfolio will have grown to $1,469,081. This leaves approximately $136,000 of growth which can be accessed via an increased line of credit. At an 80% LVR, that provides an additional $108,000 to be drawn.
After deducting the annual costs of maintaining that extra borrowing at 10%, that still leaves nearly $97,000 to provide a buffer against the increased interest costs. That equates to almost another year within which to consider your options. Of course, if we were to add in the tax benefits of the now increased interest deductibility plus any non-cash depreciation deductions, the picture begins to look a lot better. The table below looks at a revised scenario for an investor on the top marginal tax rate.
Rental income @ 4% on $500,000 property ....... $20,000
Share dividend income @ 4% on $332,500 ........ $13,300
Income from the cashbond, say 4.5% on $133,000 . $5,985
Total income .................................. $39,285
Interest on LOC @ 10% on $400,000 ............ ($40,000)
Interest on IP loan 10% on $400,000 .......... ($40,000)
Interest on margin loan @ 12.5% on 199,500 ... ($24,938)
Property costs @ 1% on $1m ................... ($10,000)
Pre-tax investment expenses ................. ($114,938)
Add back tax benefits ......................... $55,745
Net loss after tax ........................... ($19,908)
A much happier outcome! This after tax cash shortfall can be easily subsidised by drawing down on the spare equity which accumulates each year. Bear in mind also that we have not allowed for any depreciation benefits. Such non-cash deductions would further reduce the after tax loss. Diagram 2 below sets out how the components of the optimised investment structure operate to get each dollar working 6 times.
 click to enlarge
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