Episode Details

Paying minimal tax probably appeals to most people. And as tax is often our biggest lifetime cash outflow, it might seem logical that minimising it is a great way to build wealth. However, I’m going to suggest that perhaps you need to pay more tax to build wealth. A higher tax bill typically means you have a higher income and therefore a higher borrowing capacity.

I have seen lots of people cut their nose off to spite their face by focusing on the wrong things at the wrong times. Sometimes tax minimisation is more important than borrowing capacity maximisation. However, the reverse can also be true too. You must understand when to focus on one and not the other – particularly in this very tight credit environment.

The wealth impact of minimising your taxes

Even a modest increase in your income can translate to a significant increase in your borrowing capacity. For example, if your taxable income increased by $37,000 from $150,000 to $187,000 it would increase the amount of tax you pay by approximately $15,000. However, I estimate that this higher income will increase your borrowing capacity by approximately $300,000. This additional borrowing capacity might be the difference between affording an entry-level investment-grade property at say $500,000 versus a higher-grade property for say $800,000. A higher-grade property should, in the long-run, result in a higher capital growth rate. The difference between the value of these two properties in 10 years’ time could easily be more than $500,000 in today’s dollars[1].

I am sure that the investor that buys the better-quality asset (at $800,000) won’t even think about the higher tax bill he had to pay 10 years earlier. This is why it’s important to take a long-term view when making financial decisions.

Minimal tax = minimal borrowing = big disadvantages?

Every now and then we receive enquiries from people that operate their own businesses and report very little taxable income (BTW, I’m not certain their tax minimisation strategies are always legal). These people then complain that the banks won’t lend them any money. I have no sympathy for people in this situation as you can’t have it both ways.

Putting aside the moral and ethical obligation to pay our fair share of taxes, we also must realise the opportunity cost resulting from self-sabotaging your own borrowing capacity. Doing so retards your ability to borrow to invest and therefore build wealth. In the past, this was less of an issue with low-doc loans. However, these days, no such options exist so if you decide to report a low taxable income then your borrowing capacity will be equally low.

Timing your tax minimisation strategies

There are several strategies that tax advisors might employ to legally reduce your taxable income including:

As the above list demonstrates, in any one year many people have the capacity to legally influence their taxable income and their decisions can have a material impact on their borrowing capacity. For example, some lenders only want to see one years’ worth of tax returns (most recent year) whereas others will work on the average of the last two years. Therefore, in order to maxim